New article published on Divestopedia
The purpose
of this article is to present earnouts to
sellers of technology companies as a method to maximize their transaction
proceeds. Sellers have historically viewed earnouts with suspicion as a way for
buyers to get control of their companies cheaply. Earnouts are a variable
pricing mechanism designed to tie final sale price to future performance of the
acquired entity and are tied to measurable economic milestones such as
revenues, gross profit, net income and EBITDA. An intelligently structured earnout can not only
facilitate the closing of a deal, but can be a win for both buyer and seller.
Below are 11 reasons earnouts should be considered as part of your selling
transaction structure.
#1
Earnouts Offset Your Historic Small Sales
If the likely
buyer is a large, publicly traded company, the acquisition of an emerging
technology company with relatively small sales will not move the needle in
terms of stock price. This will dampen the effect of potential upside for the
smaller company that agrees to take stock in the buying company. Generally, for
smaller acquisitions, the buying companies are reluctant to use their company
stock as the transaction currency. The earnout allows the seller to leverage
his/her upside on the very focused performance on his/her product as it
performs under the new owner. Let's look at a hypothetical example:
Small Company
A has current sales of $2.5 million and is acquired by Large Company B, which
has sales of $20 billion. If Company A's sales increase from $2.5 million to $5
million, $10 million and $25 million in years one to three post-acquisition,
respectively, it is almost invisible when lumped in with $20 billion sales
level. Therefore, there will be little movement on the stock price. A far
superior outcome for the seller would be to have a three-year earnout that
would pay him/her 10% of revenues over the base level. So, take the total sales
for the three years post-acquisition of $40 million, subtract the combined
target level of $7.5 million and you get $32.5 million. Multiply this by 10%
and you get an earnout payment of $3.25 million. This normally will be far
greater than the increase in the large company's stock value over the same
period.
#2 Buyers'
Multiples at Pre-1992 Levels
Buyer
acquisition multiples are at pre-1992 levels. Strategic corporate buyers, privateequity groups, and venture capital firms got burned on valuations.
Between 1995 and 2001, the premiums paid by corporate buyers in 61% of
transactions were greater than the economic gains. In other words, the buyer
suffered from dilution. During 2008 to 2013, multiples paid by financial buyers were almost equal to strategic buyers'
multiples. This is not a favorable pricing environment for tech companies
looking for strategic pricing.
#3
Investor Skepticism Equals Better Price with Earnout
Based on the
bubble, there is a great deal of investor skepticism. They no longer take for
granted integration synergies and are wary about cultural clashes, unexpected
costs, logistical problems and when their investment becomes accretive. If the
seller is willing to take on some of that risk in the form of an earnout based
on integrated performance, he/she will be offered a more attractive package
(only if realistic targets are set and met).
#4 Buyers
Like Sellers Willing to Share Post-Closing Risk
Many tech
companies are struggling, and valuing them based on income will produce some
pretty unspectacular results. A buyer will be far more willing to look at an
acquisition candidate using strategic multiples if the seller is willing to
take on a portion of the post-closing performance risk. The key stakeholders of
the seller have an incentive to stay on to make their earnout come to fruition,
a situation all buyers desire.
#5 Part of
Watermelon Better Than All of Grape
An old
business professor once asked, “What would you rather have, all of a grape or
part of a watermelon?” The spirit of the entrepreneur causes many tech company
owners to go it alone. The odds are against them achieving critical mass with
current resources. They could grow organically and become a grape or they could
integrate with a strategic acquirer and achieve their current distribution
times 100 or 1,000. Six percent of this new revenue stream will far surpass
100% of the old one.
#6
Guaranteed Multiple with Earnout
How many of
you have heard of the thrill of victory and the agony of defeat of stock
purchases at dizzying multiples? It went something like this: Public Company A
with a stock price of $50 per share buys Private Company B for a 15 x EBITDA
multiple in an all stock deal with a one-year restriction on sale of the stock.
Lets say that the resultant sale proceeds were 160,000 shares totaling $8
million in value. Company A’s stock goes on a steady decline and by the time
you can sell, the price is $2.50. Now the effective sale price of your company
becomes $400,000. Your 15 x EBITDA multiple evaporated to a multiple of less
than one. Compare that result to $5 million cash at close and an earnout that
totals $5 million over the next three years if revenue targets for your
division are met. Your minimum guaranteed multiple is 9.38 x with an upside of
18.75 x.
In the second half of this two-part article, I will explain the
final five of the 11 reasons why you should consider an earnout when
structuring the sale of your business.
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