An earnout is a mechanism used to bridge the gap of perceived company value between the buyer and the seller. In most deals, the seller believes their company is worth more than the buyer wants to pay. In our M&A work, we have never seen a buyer come in with a letter of intent that contains such a strong offer that the sellers says, “Wow, I can’t believe they are giving us so much money!”
If an investment banker is representing you in the sale of your company, they can fairly accurately predict what the incoming offer will be, ballpark. There are “swim lanes” that most buyers stay in as for the multiples of EBITDA being used to value LBM companies. We subscribe to an expensive database that reports these multiples and values from other deals in the LBM sector. Still, even when you’re prepared, a seller’s response upon getting an offer goes more like this: “Well, it’s not bad, but it’s not as high as we would like.”
First, note that the purchase price offered in the LOI is almost never the final offer. As a rule of thumb, there can be a 10% swing to the seller’s advantage; your investment banker should provide the metrics and negotiating firepower to argue for more cash. So, a $10 million offer can get pushed to $11 million. That said, let’s say you and the buyer are still far apart on price, yet you like the buyer, and you want the deal to work. How do you bridge that gap between the buyer’s offer and the seller’s bottom line number? In absence of the buyer simply adding more cash when asked to pony up (fat chance), this is when an earnout is a perfect mechanism to bridge the gap.
The seller can go back to the buyer and say, “We want you to win the deal, but we need $1 million more to achieve our bottom-line goals. Why don’t you pay us $10 million in cash at the closing, and another $1 million a year from now?”
The buyer may say: “Ok, I think we can. But we have to put financial performance goals in place. If you achieve the goals 12 months from now, we’ll pay the additional $1 million.”
This is just one area where your investment banker really earns their fee. The buyer will want to structure the $1 million payment on A) aggressive performance goals, a.k.a. stretch numbers, B) the earnout will be based on EBITDA, and C) they will want the earnout to be “all or none,” meaning that you either hit the goal, or not. A penny under, then there’s no $1 million payment.
In response, your investment banker should say that A) the stretch numbers are too high; let’s have something realistic in place. A good method would be to forecast using multi-year average growth trends. B) You should not base the earnout on EBITDA, because it’s easy for the new owner to suppress that EBITDA by manipulating expenses. Just adding a new regional sales manager with a $150,000 pay package, and another $50,000 in new marketing expenses can cripple the seller’s ability to meet the EBITDA goal required to get the $1 million. Instead, base the performance goal on sales revenue, not EBITDA. And C) the earnout can’t be all or none. It should be gradated. For example, if the sellers achieve 75% of the performance goal, they get 75% of the $1 million. But also put a floor in place as well, so that under no circumstance shall the seller receive less than a certain amount of the earnout, no matter what happens (e.g. a virus pandemic); say 50%.
A one-year earnout is an ideal time, if an earnout is required at all. Some buyers will push for earnouts to be multi-year, in part because they are trying to use the future proceeds of the company to help pay for it. But the longer you go out in time on earnouts, the more you lose control of the very aspects of company operations needed to achieve the target performance, because, remember, you’ll be an employee with diminished power, and not an owner. So, shoot for, max, one year on earnouts. And have your investment banker advise you on their structures.
John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at firstname.lastname@example.org