Article provided by Chris Staines, Director at BDO Corporate Finance
In an earlier article, I covered a simple rule of thumb method for determining the value of your business, and explained that often the best way to approach this is via the product of a ‘multiple’ applied to the Future Net Maintainable Earnings (FNME).
Whilst this simple approach can provide the owner with a snap-shot of a likely value, it is fair to say that most private company exits I manage tend to use a far more complicated structure when it actually comes down to negotiating the deal – the earn-out.
So what is an earn-out?
In simple terms, it is a means of leaving the ultimate price that a buyer will pay for a business, in part, down to the future performance of that business – i.e. not making it just a function of your estimated FNME and an industry applicable multiple. So with the rule of thumb method, we might have determined that the FNME was R10m, and that the most appropriate multiple was, say, 6 – and hence the value was R60m.
In an earn-out, two additional factors come in to play. Firstly, from the buyer’s side, despite every assurance from the seller that future profits will evolve as shown in his FNME calculation, he would much prefer to de-risk his purchase by asking the seller to put his money where his mouth is. In other words, he wants some of the purchase price he is prepared to pay to be dependent on future profits actually earned, not just promised.
Secondly, from the seller’s side, despite having arrived at a reasonable estimate of his FNME, he might feel that this number averages out his future earnings potential rather than really showing how actual profits might really accelerate in, say, years 2, 3 or 4 – and which the FNME calculation will have discounted to some degree given their distance into the future.
So, very often, the agreed solution to the buyer’s reluctance for risk and the seller’s bullish assessment of his company’s future is to structure a deal whereby only part of the purchase consideration is paid now, and the balance is calculated dependent on future performance.
A simple example
Imagine a company that had net profits after tax of R6m last year, will make R9m this year, is predicting R12m next year, and then R16m the year after that. And through a weighted average process, both buyer and seller have agreed that the likely FNME for the business is indeed R10m – i.e. applying most weight to the current and subsequent year, whilst also looking back in time to check the profit history, and believing some of the future promises for profits from the forecasts provided. When it now comes time to actually structure the deal, both buyer and seller agree that they can do better through an earn-out structure (i.e. with regards to relative risk and value as explained above).
A simple earn-out might therefore be structured by the buyer as follows:
- Current net profit before tax (R9m) x multiple (6) x 50% = R27m
- Year 2 net profit before tax (R12m) x multiple (6) x 25% = R18m
- Year 3 net profit before tax (R16m) x multiple (6) x 25% = R24m
Total consideration = R69m
Flexibility, penalties and incentives
Looking at the above, you might well ask whether receiving R69m spread over 3 years is in fact any better than receiving an up-front payment of R60m (if the buyer was prepared to pay this – most times not!). There is little to choose between them. But this is where the flexibility of the earn-out, and its complications, now come into play.
The first change that buyers might offer, or sellers demand, is a variable multiple relative to performance. The buyer can lay down a challenge to a vendor by saying that, if you really think you can get from R9m this year to R16m in year 3 (and bear in mind this might only be less than 24 months away depending on when the R9m was reported), then I will incentivise you to do so by raising the multiple from 6 to 7. But, by the same token, if things do not go as well as you are predicting, I want to cover the risk that I have overpaid in years 1 and 2, and hence if your year three earnings are below R12m (say), the multiple falls to 5.
As you can see, the permutations for adjusting the earn-out through the percentage paid up-front, the relative splits of consideration between years 1, 2 and 3, the length of the earn-out (some are only 2 years, others up to 5), the variations in the multiple to be applied etc. etc. are legion.
And, if this was not enough, there are also the regular inclusions of caps (maximum levels the buyer will pay at each stage of the earn-out regardless of profit performance) and collars (amounts below which consideration cannot fall regardless of how badly the seller performs) to provide upside and downside protection for each.
Other nuances might include the split between cash or shares offered as consideration (if a listed buyer) – in fact the list of variations is almost endless. And this is where the principal problem with earn-outs comes in.
Buyer and seller behaviour
For an earn-out to work, it should be clear from above that the seller needs to be largely left to their own devices throughout the term of the earn-out to achieve the profit targets that have been set so that they can maximise their outcome. The more complex the calculation, so any interference from the buyer could be construed by the vendor as detrimentally affecting the consideration that could be earned in each year.
From the buyer’s side, this kind of vendor behaviour can be equally problematic. Armed with the knowledge that each Rand NOT spent on, say, R&D or marketing actually increases the earn-out, the vendor is unlikely to make an investment in the future of a company in which he will play no part. The buyer’s inclination, therefore, is to get involved where he can to moderate such behaviour – usually regarded as an unwelcome interference by the seller.
The only way to ensure that an earn-out can work, therefore, is for the purchase and sale agreement to have a comprehensive and detailed list of rules and regulations for both buyer and seller, with remedies and adjustments in place if these are breached.
It should be noted that not every action by a buyer is always detrimental to the performance of the company during its earn-out, and more often than not the buyer will provide working capital, admin support, introductions to new markets to increase sales, etc etc. in an effort to grow the business for the future. So some adjustments to the earn-out are actually put in place to discount the benefits that these actions unduly bring to the seller, as the buyer does not want to be penalised by paying more for the very enhancements that he has brought to the business.
Earn-outs are complicated beasts. Far too often buyers and sellers go wading into complex formulae with rules, incentives and penalties in place with the naïve belief that all can be applied seamlessly throughout, say, a three year term. In an effort to protect their position, vendors can demand ever more complicated protections (such as the staged acquisition of their shares as opposed to a pure split of consideration) in the hopeful belief that a better structure leaves them with more power until the last consideration is paid.
From the buyer’s side, now that they have bought their shiny new toy, more often than not the temptation to start playing with it is just too great, and they will be frustrated that they cannot bring many of their own resources to bear. On the one hand they want the vendor to behave with a longer-term future (in which they play no part) in mind, and on the other hand they want to enhance the performance of their purchase but not allow the seller to benefit from this.
Despite all of the complications and frustrations, earn-outs remain enduringly popular, with no two structures every looking exactly the same. Vendors are just too tempted by the opportunity to really cash-out when their business will be ‘flying’ in two or three years’ time to worry about the inherent complexities that will inevitably frustrate such an outcome. By the same token, buyers are keen to incentivise owners to achieve these stellar profits, and will pay for them, but at the same time are desperate to cover their downside should these targets not be achieved.
Despite their popularity I would guess that at least 50% of all earn-outs end in tears, with the preferred remedy being a buy-out at an agreed lump sum for the balance of the earn-out, and with both parties ultimately going their separate ways. This may not be an altogether bad outcome for either party, but does somewhat call in to question the benefits for either party of entering into such an inherently unstable deal structure mechanism in the first place.