Beware of financial engineering

We took a successful, growing company to market recently, and a buyer quickly stepped up with a verbal offer to pay a premium over what the owners expected for their company, while asking that it be taken off the market. The buyer wanted to stop the offering altogether, offering a market-clearing price. Their underlying motive was to avoid competing with other acquirers in bidding wars that might emerge in a controlled auction.

Make no mistake, this offer (a.k.a. a “pre-empt”) had a wow factor. The sellers liked the price. We invited the acquirer to reveal the deal structure. That’s when it started to unravel.

For this example, let’s say that this potential acquirer wanted to pay $20 million for the target company on a cash-free/debt-free basis. Let’s also assume the target company was operating at a $2 million EBITDA. The company’s projections were attractive and realistic, showing $2.5 million in EBITDA in the current year, moving to $3 million and $3.5 million EBITDA in the subsequent two years.

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But the offer depended on some clever “financial engineering.” First, it’s common for acquirers to ask sellers to stay with the company, and to put some of the equity back into the new company. Let’s say that the acquirer asked the sellers to leave behind 10% each, totaling 20%. Right away, the potential acquirer reduced the cash required at close by 20% of their $20 million offer, leaving $16 million to come up with.

Next, while working to minimize their cash requirements, the acquirer then offered to put down $7 million in cash-at-close. Based on the target company’s strong balance sheet, most of the $7 million would have been raised through senior debt and mezzanine financing, which would end up on the balance sheet of the company post-close. In effect, the buyer had to put up very little of their own money to buy the company for $20 million valuation.

But with $7 million in cash, that still means they had to make up the “missing” $9 million of the offer.

Ok, just to recap, the potential acquirer offered $20 million, minus the owners’ equity, so $16 million was required. Then, deduct the $7 million cash-at-close, and just $9 million was required. Where would that come from?

The potential acquirer then proposed paying $9 million over three years, an earnout, in this manner (tied to performance metrics): $2.5 million in the first year, $3 million in the second year, and $3.5 million in the third year, for a total of $9 million. You’ll note that these figures are identical to the projected EBITDA.

Does this look fishy?

Yes, it does. Here’s why: The potential acquirer was using financial engineering in an attempt to obtain a $20 million company by risking very little of their own money. After the sellers give up their equity in the new company, the potential acquirer is essentially paying for the business out of the future proceeds of the business.

What’s off here is that the sellers are really getting only $7 million in “guaranteed money,” plus the future value of their equity, but that’s in a company they will no longer control. In the clear light of day, you realize that the sellers are being asked to allow money they would have taken as disbursements (three future years of EBITDA) to pay themselves for their own company…all while giving up ownership!

Further adding to the risk profile of this offer, the buyers would likely put covenants in the purchase agreement that state the earnouts will be made only if certain performance metrics are met. Whereas the seller should always tie that performance to top-line revenue, or gross profit dollars, buyers typically want it tied to EBITDA. However, EBITDA is the line item that can be easily manipulated, and EBITDA could easily be driven below the threshold where the earnout payment is triggered.

Make no mistake, the potential acquirer is being quite clever. These types of structures are common, but they are common for companies that are distressed, or are cornered by debt, or are desperate to sell. For successful, growing companies, there is simply no need to allow an acquirer to pay you with your own money. In a case like this, we would advise that you “walk the deal,” and find another structure that has less risk and more cash at close.

John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at j.wagner@1stwestma.com.

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