How earnouts change valuation multiples

John Wagner - working capital peg

When a company owner decides to go to market and seek an acquirer, he or she typically searches around for an investment banker (a.k.a. the seller’s rep, or “broker”). It’s recommended that you interview at least a couple of investment bankers. That way, you can get an idea of the success fees they charge, the retainer they charge, and their go-to- market strategy. If you engage in this process, you’ll probably be struck by how different each firm can be, because each has its own personality, various levels of service, and different fee payment schedules.

In interview conversations like these, our firm is regularly asked about our fees and how we “shop a deal,” but there is one other question that seems always to be asked in these early conversations: “What value do you think you could get for a company like mine?”

We can’t always immediately answer with a dollar figure. Here’s why: There are so many variables in terms of calculating a company’s value that it’s too early in the engagement to make a confident estimate on a first phone call. We need to at least see the financials of the company and look over the operations before rendering an opinion.

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That said, we can discuss the contemporary “multiples of valuation” being paid for companies today. Most firms, ours included, subscribe to very pricey databases that show actual multiples paid for recent deals in our LBM, distribution, and manufacturing sectors. (As quick background: Those multiples are paid as a multiplier of EBITDA. For ease of math, if your company has $5 million in EBITDA, and the going multiple for companies like yours is 6X, then your company is worth $30 million.)

Now, it’s human nature for sellers to overvalue their companies. And their houses. And their cars. And their gun collections, etc. So, a seller may choose to go with an investment banker who estimates the value of their company along the lines of the seller’s expectations. Fair enough. The investment banker may be eager to land a new client, and he senses that a high value estimate will win the deal. But you must be careful to see if the banker is just telling you what you want to hear. A reputable firm will always be prudent and realistic, carefully citing the going multiples, regardless of the number the seller has in mind.

Many conversations we engage in contain exchanges like this: “You’re telling me 6X EBITDA for a company like mine, but I just talked to an investment banker who said he can definitely get me 8X, or even 9X.”

Well, maybe that broker can get that 9X, but here’s how it would typically happen: The multiples paid that end up in these deal databases are mostly all-cash deals, and all- cash deals are risk free for the seller. Let’s say that 6X is the going multiple, but a seller won’t sell unless he gets more. If the buyer is really interested, he will use an earnout as a way to bridge this gap in valuation. That 6X figure may be paid at closing, and then a one, two, or even three-year earnouts can bring the seller more cash, if he shares some risk with the buyer. In other words, he takes 6X now, and sets performance goals that, if met, bring him more money over time.

The longer the earnout period, the higher the risk, and the higher the multiple ultimately paid, once everything is tallied up, years hence.

After all the earnouts are paid, the deal maybe indeed achieve a higher multiple than the average paid today, but you, the seller, have rolled the dice with a new owner. And in the process, you may actually lose control of the very company operations that will help you achieve those performance goals, like marketing budgets, hiring authority, product mix, and deal-making privileges.

Can you get 9X in a market where the average is 6X in cash? Yes, possibly, but over time, and at higher seller risk, because you simply can’t predict the control you’ll retain, nor the economy, nor even other companies that may be subsequently acquired and joined with yours.

Most people who’ve been around the block know that cash is king, and the reason that this old cliché is still spoken, is because it’s so true: A bird in the hand is worth two in the bush.

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