“Pricing in” a recession

inventory - John Wagner

As we head into the thick of 2019, you can read predictions from economists all day long about what the future holds. One will say there’s a recession coming; the next one will say we’re set for growth, and the third will say it will be a flat year. (You may even see predictions that the price of tomatoes will rise, but ignore that. That’s because business owners are buying up the tomatoes to throw at the economists.)

No matter what the fate of the economy, in the world of mergers and acquisitions you can rest assured that prospective buyers of your company will try to leverage economic uncertainty and recessionary storm clouds to offer less for your company than they would in a time of economic growth. That should not come as a surprise. There  is always a natural tension between sellers (the optimists) who want the highest imaginable valuation, and buyers (the pessimists, at least temporarily) who want to drive the valuation lower.

That said, exactly how would acquirers drive down the value of your company to price in or guard against a potential recession? They will do this in at least two ways: Offering a lower multiple paid for your company, and the implementation of earnouts.

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First, as background, let’s review a topic I covered in a re- cent column: If you are selling a company with a $3 million EBITDA, and it’s valued at 5.5X (a typical multiple in a good economy for an LBM business), your company value is $16.5 million. However, if there are recessionary clouds on the horizon, the buyer will likely price in the potential slow- down by lowering the multiple he wants to pay. Just drop- ping the multiple from 5.5X to 5X will lower the purchase price by $1.5 million. (As you see, even a “half turn down”— just a slight softening—can have a dramatic and negative effect on value.) So, in a recession, or even in the face of      a prospective recession, a buyer may simply offer a lower multiple for your company in anticipation of a downturn.

A second technique for pricing in a recession is an earn- out. An earnout is a risk-allocation vehicle that can bridge the gap in value between the buyer and the seller. Essentially, with an earnout (as spelled out in the purchase agreement), part of the purchase price for the company is deferred.

The earnout, which is usually a relatively small percentage of the overall deal value, is paid over a specific period of time, post-closing, based on the performance of the acquired business. Essentially, the buyer says, “I think the market will soften, so I want to pay less.” The seller says, “I think the market will be strong, so I want you to pay more.” The earnout can bridge the gap, essentially saying: “Hey guys, let’s put a mechanism in place that will reward the correct party a year from now, or two years from now, when we see who’s right.”

The earnout approach will work only if the seller agrees to peg a future payout to certain performance metrics. If the metrics are achieved, the seller gets the earnout; if the seller misses the mark, he won’t get the earnout (or gets only a fraction). For example, in the simplest terms, assuming a $3 million EBITDA, you may get 5X at close and receive $15 million. Then, an additional 0.5X is paid a year after close ($1.5 million more), if you perform.

Earnout structures can be remarkably creative, and they are based on all (or some) of a range of performance metrics, such as gross revenue, sales revenue, net profit, or EBITDA. When structuring them, here’s a word to the wise: Some buyers will want earnouts to be “all-or-none.” If the seller agrees to, say, achieve $20 million in revenue per location, the buyer may want to pay out zero dollars if the seller comes in at $19.9 million. So, when structuring an earnout, drive to make it graduated, not all-or-none. If you achieve 80% of your goal, you should get 80% of the earnout. If you reach 90%, you get 90%. You can also structure an earnout to reward you if you exceed the amount targeted in the earn- out. Say you kill it in 2019, and achieve 110% of your earnout target. You should be rewarded for that extra performance. If you’re a seller, and you have a good investment banker advising you, he or she should be putting these ideas in front of you and driving to have them accepted.

Finally, make sure to maintain control of your operations. If the earnout performance metric is EBITDA, and the acquirer layers in corporate overhead, you have just lost some control of your EBITDA. Protections against this and similar occurrences can be built into a deal structure by a good advisor.

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