Archives for March 2011

How Common Are Earnouts?

March 24, 2011 By Ney

How often are earnouts used? Small businesses generally don’t use earnouts and for good reason. In small business transactions there are typically short transition periods (usually sellers “earn” an earnout by staying during a transition), financials are often fairly messy so measuring earnout milestones are problematic, and buyers usually want to come in and operate the business as theirs without any of the operating limitations that often occur with an earnout arrangement. They occur with small businesses, but it is not common.

However, they are fairly common for larger companies in the lower middle market and middle market. Valuation gaps between buyers and sellers are common, and that naturally leads to discussions on earnout.

It is also fairly common for earnouts to disappear later in negotiations when the challenges of actually structuring the earnout become apparent. For example, how to measure the earnout, how long to make the earnout period and what operational limitations will be placed on the buyer are all typical issues to be worked out with earnouts (my next blog post will look at these in more detail.)

For example, last year I did a deal in which there was initially an earnout. During last minute negotiations with the two buyers still left bidding, one of the buyers dropped the earnout and made that payment a non-contingent note. That swung the deal his way and the next day the seller signed that buyer’s LOI. It also simplified the purchase agreement that would soon come.

The American Bar Association puts out a deal points study in which they organize deal information from a number of middle market deals. In 2007, they analyzed 103 deals and 20% of those deals had earnouts structured into the agreements. In 2009, 104 deals were analyzed and 29% had earnouts, which makes sense given the higher volatility and risk of earnings in 2009. Those deals were squarely in the middle market between $20 million and $100 million. For lower middle market deals at $20 million and below I think there are around 50% of deals that have earnouts.

Earnout Series: How to Tell if an Earnout is in Your Future

March 21, 2011 By Ney

Some of my clients tell me they would never accept an earnout, but then go on to say how they believe the historical earnings don’t tell the whole story and that a buyer needs to believe the company will grow in the future. In other words, pay more. Unfortunately, many buyers will say, “I don’t quite believe you, prove it”. And that’s an earnout. Here is how to tell if an earnout makes sense when you sell your business.

When are Earnouts used?

An earnout is contingent future payments based on performance milestones. For example, in a simple earnout arrangement an extra payment of $100,000 to the seller may be “earned” by growing the company by an additional $1 million in revenue in the 12 month period after the close of the transaction. Earnouts are used when there is a difference of opinion on what the earnings will be in the future. The buyer says, essentially, “show me”. Earnouts are well known in the technology sector; however it really has more do with high growth scenarios than technology.

Business are Bought for Future Earnings

In looking at Earnouts, it is useful to remember that what a buyer really cares about are future earnings. Since we don’t know what future earnings will be, we generally use historical earnings for valuation. Earnout discussions naturally arise when there is a significant difference between historical earnings and future projections.

Let’s look at a few scenarios of historical vs. projected earnings.

Scenario One – Stable Earnings

This company has a stable history and a believable projection. It isn’t hard for anyone to believe that projection. In other words, the risk is fairly low, and the seller should not expect an earnout.

The purchase price in this case should be comprised of cash and possibly a note, but unless there are other risks, the note shouldn’t be contingent on revenue or earnings – and there should not be an earnout.

Scenario Two, Supported Growth

In this scenario it is also easy to see where earnings are heading – up. In other words the projection of future growth is clearly supported by historical trends. However there is often some discussion about who is going to benefit from the growth. A seller may say, “You can see what will happen, so I want to base the purchase price on a high multiple, or possible use next year’s earnings”.

A buyer, on the other hand, may say that if the company grows, it will be because of his effort after he buys the company, not the sellers. After all, he certainly isn’t buying it to give all the earnings to the previous owner.

A smart seller will counter this by explaining that much of the future growth is because of the foundation he has built. The website, reputation, product, service, etc. have all come to together to build momentum that would be difficult to stop. However, what he is also saying is, “Just trust me on this”. No one likes to bet hundreds of thousands or even millions trusting someone you recently met, so earnout discussions start.

In this type of scenario, an earnout could look like the following:

A “base price” of cash and notes is calculated using historical performance, and an earnout is structured based on the company hitting certain targets. The target may be a revenue or earnings milestone or just about anything that makes sense. The next blog post will cover typical earnout stuctures.

Scenario 3, Unsupported Growth

We often (too often) see a scenario where the company doesn’t really have an upward trend, yet the business owner believes there could be a lot of growth opportunities. For example, the owner may say, “I never got around to putting up a website but if you built a website and sold products online, sales would double.” In this case the buyer does have a pretty good case to say, “Well, if I spend the money and time to build the website, then I should enjoy the rewards”.

Sometimes we can negotiate an earnout in this type of scenario, but it really depends on the situation and why exactly the seller believes growth is inevitable.

Scenario 4, Recession Proofing a Transaction

Although earnout agreements are mostly seen in growth companies, we’ve also seen it a few times in protecting the buyer from further decline during the recession. Many companies have seen a retraction of sales and earnings from the time before the recession, and that is just fine with buyers – as long as the performance has stabilized. We’ve seen buyers, fearful of further decline, set a purchase price on a lower “base” number, then set up an earnout target of simply staying put. In other words, if the business does the same in revenue and earnings in the future, then additional payments are made to the seller. If the business slides some more, then the seller gets the “base” price that was somewhat lower.

In the next few blog posts, I’ll cover how frequently earnouts happen, and how they are typically structured.

Childcare Facility: How Much is it Worth?

March 19, 2011 By Ney

I received the following question from my national blog:

NAME: XX
COMPANY: YY
TITLE: Owner

COMMENTS: I have owned my childcare facility for 15 years and I am carefully considering buying an existing childcare for sale. I found your article about how much a business should sell for. This business for sale grosses 550k @ 70% capacity and the sellers records showed 75k profit. The are asking 300k. I feel 200-225k might be more appropriate. Any advice? Thank you, I emailed because your article has been the most imformative incising people I have talked to and research conducted!

Sincerely, XX

My response:

Dear XX,

Thank you for the note. I would agree with you.

First, you need someone to make sure about that earnings number. But if it is seller’s discretionary earnings of 75K, that means one owner made $75K per year owning and running that business. That isn’t all that much. Really they are selling a job (as opposed to something that is creating cash flow that you can save for a return on investment). A nice job with some perks, but also some hard work. A multiple of 4 is too much. Often companies with earnings under $100K go for 2 to 2.5 earnings.

I admit I don’t know much about the market and multiples for small childcare facilities. However, there are many that are sold each year and that data is accessible. My associate Fred Hall does business valuations for banks and business owners. He recently launched an inexpensive appraisal business that will give you comparable transactions around the country, and will really narrow down that multiple for you for that level of earnings. You can reach him at: www.affordablebusinessappraisals.com. I’ve copied Fred on this message in case you want to ask him questions.

If you are serious about buying this business it would be well worth the few hundred dollars to find out what these businesses really sell for.

Regards, Ney

How To Increase the Value of Your Business: Top Ten List

March 12, 2011 By Ney

Don’t wake up one morning and decide to sell your business. Wake up and decide to plan for your exit. Because if you have a year or two to plan, you can tangibly increase the value and the selling price of your business. How?

1. High Earnings = High Selling Price. Pretend nothing else matters, because, well, nothing does. At least not enough that if you had one thing to focus on to increase the value of your business, this is it.

2. Depreciate. Earnings (both discretionary earnings for small companies and EBITDA for larger ones) don’t include depreciation expense. For tax reasons business owners tend to expense rather than capitalize and depreciate, but in the year or two before a sale? Depreciate.

3. Reduce Working Capital Needs. A midsize company is sold with enough working capital (current assets minus current liabilities) to continue to operate the business. Think of it as having to sell your car with gas in the tank. Prove you can reduce this amount now (e.g. lower AR, lower inventory, increase payables, etc.) and you can take more cash home in the deal later.

4. Nix the C-Corp. If you think it will be a number of years before you close a deal, see if you can take an S-Corp election. Most buyers will want to do an asset sale (more on this later) and the double tax created by a C-Corp can be extremely painful.

5. Concentration Is a Bad Word. Businesses with high customer concentration or supplier concentration (or knowledge concentration, etc.) attract fewer buyers and this lowers the price. What’s too high? Having a customer with 25 percent or more of your business, or having a supplier with 40 percent of your business is too high. Diversify if at all possible.

6. Make Yourself Unimportant. What business would you rather buy? The one where the owner takes frequent trips and takes every Friday off, or one where the owner has to come in even when he is sick because the place will fall apart without him. A company that relies on the owner gets far less cash up front and often less overall.

7. Pay Some Taxes. Yes, everyone plays the tax avoidance game, but only to a degree. A broker/advisor can only adjust earnings only so much, so it is far better to just pay your taxes for a few years before a sale than the complications that can arise otherwise.

8. Understand What “Adjusted Earnings” Means. Well before a sale is the time to understand what adjusted seller’s discretionary earnings and/or EBITDA means. For example, some expenses will be valid adjustments, so there would be no need to work on reducing that expense, while other areas may need some real focus.

9. A Risky Business Is a Cheap Business. A legal issue dragging on? Environmental problem lurking? Buyers hate risks and risks tangibly lower the price. Identify and attack these areas before a sale.

10. Pick That Low-Hanging Fruit. We hear many business owners say things like, “Pay me X, because you can easily grow this company by doing Y, but I didn’t want to do that because of Z”. For example, “All you have to do is hire a sales manager but I didn’t because I don’t manage people well”. If you have an easy way to boost sales, do it, because you are not going to get X otherwise.

Note

This list came from an extended list of “101 Things You should Know about Selling Your Business”.

Quick Trip to See “On Hold” Clients

March 6, 2011 By Ney

Southern Sierras_1024_768 — Southern Sierras

The recession has put a few of my clients that are selling their businesses into a holding pattern, and I thought it would be a good idea to visit them and see how they are doing. So I made a circuit of three clients in Las Vegas (Henderson actually), Temecula and Burbank.

It was very cold, so I preheated the plane before heading out to Henderson. The client was nice enough to meet me at the airport so we just hung around, looked at airplanes and talked. He has some awesome opportunities before him, so I’m confident he’ll come back on the market within a year or so. I then flew into the sunset and on into French Valley airport for the night. I met a prospective client the next morning for breakfast, and then flew to Burbank to meet my next client for lunch.

This client has a solid company that seemed recession proof. We even had an offer on the company in 2009, but unfortunately there were very few companies that were recession proof in 2009 and he took a hit and took himself off the market. Things are looking up again, and we’ll see him back on the market in next year or two as his earnings rise and stabilize again.

I didn’t have to because the ceiling as at around 7 to 8,000 feet, but I flew at 10,000 feet all the way home in the clouds so I could get some safe but good solid IMC (instrument) time. All in all a good trip. It was nice to connect with my clients, the plane ran well, and it was a fun challenge to deal with the cold, the weather and the incessant LA air traffic.