Even with the hot M&A market, earnout structures remain an important strategy. There is enduring support for strong acquisition values, but buyers of LBM companies are not exactly splashing cash around like drunken sailors or newly elected presidents. When discussing deals with buyers about to submit LOIs (letters of intent), we consistently hear phrases that sound like this: “Well, we certainly are interested, and we know there are other parties circling this deal, but we don’t want to over-pay for it.”
Fear of over paying is driving buyers to offer top prices, but to hedge their risk around two issues that have emerged during the pandemic:
1) the so-called “COVID Bump,” where we have seen hyperactivity of people buying building supplies, and 2) the run-up of commodity lumber prices, where you’re probably making the same gross profit margins you’d made pre-pandemic, but your realizing more gross profit dollars as a result of higher prices for things like OSB, framing packages, etc. Those two market dynamics are genuine concerns for buyers, because of their heightened concerns over how sustainable the earnings are as the pandemic ramps down, and lumber prices (hopefully) come back to Earth.
To manage that hedge, buyers are using a traditional instrument—the earnout—to bridge the gap in value perception for the seller (who wants full value on all earnings, even COVID-19 and higher commodity prices) and the buyer who loses sleep night after night, thinking a crash is going to happen exactly two weeks after they sign a big check.
We’ve seen two creative earnout strategies recently, one bad for the seller and one good for the seller, and they looked like this, starting with the bad one.
In the first case, the buyer was very cautious. They offered a chunk of cash for the deal at close, around 70% of the purchase price. Then, they spread the remaining 30% over the ensuing three years, when they would pay the seller any EBITDA over a certain dollar amount, each year, until the agreed upon purchase price was achieved. If the purchase price was not fully paid out to the seller after three years because of EBITDA shortfall, the seller had to eat the difference. If the buyer paid out the agreed-upon purchase price before the three-year period, they buyer would not pay more than that, even if the EBITDA soared above projections.
This offer, of course, was rejected out of hand. It’s ridiculous. First, it’s based on EBITDA dollars. Under a new owner, EBITDA can be easily driven down if the new owner elects to jack up OPEX, with such things as new marketing, new hires, etc. What’s to stop the new owner from seeing their exposure on an upcoming earnout payment, and simply drive up expenses to reduce (even to zero) the amount due to the seller? Second, a three-year earnout is overlong. You really should aim for one year, because who’s to say how the business will be run under new management two and three years hence. There’s way too much risk for the seller here.
A second earnout we saw was much more collaborative and accommodating to the seller, and we accepted it. The total potential earnout was $2 million. It could be achieved in just one year, not three. And it was based on gross profit dollars, not EBITDA, which is something we insist on for all our clients.
It was structured like this: Since we were projecting that our client, the seller, would grow at 25% in the first year of new ownership, the buyer said, “Once you reach last year’s gross profit dollar figure, we will pay out $1.25 for every gross profit dollar above that, until the $2 million is fully paid.” Note that the “.25” in the $1.25 is the projected growth rate.
In any earnout, a buyer won’t pay for zero year-over-year growth. Not surprisingly, this buyer is paying only for year-over-year growth. They are paying a fair premium on every dollar above last year’s gross profit, while putting an incentive in place for the sellers to blow through the projections as fast as possible.
Quick review: When negotiating earnouts, always base them on gross profit dollars; contain the period to max one-year; and structure the earnout so the buyer can hedge their risk, yet reward you, the seller, for the growth that exceeds last year’s performance.