Thursday, March 28, 2013

Building Your Earn Out formula for good and bad outcomes

We were recently involved in a Vendor/Buyer dispute over the terms of an Earn Out.

To clarify Earn Out: In this case, the earn out was designed to allow the Buyer to pay fair market value for the business based on the last two years trailing EBTIDA and reward the Vendor for increases above that baseline going forward for a three year term. The valuation challenge revolved around the Vendor having several very large quotes outstanding. Winning any one of those potential projects created a material increase in EBITDA when received. The balancing act is the Buyer would not pay for what had not happened yet, and how the Vendor should be rewarded fairly for known pending opportunities over and above traditional activity levels. 

The spirit of the agreement was to enable the Buyer to receive the benchmark EBITDA he was paying for. The final agreement established EBITDA levels over and above that bench mark would be paid to the Vendor 100% for the first year, 75% for the second year, and 50% for the third year. Initially this seems pretty straight forward. No exceptional sales and the Vendor receives a fair price. With exceptional sales the Vendor shares a “slice” and the Buyer expands operations and future value of the business. 

What are the primary risks for both sides?

Buyer Risk:
Buyer has little Earn Out risk above the purchase price as the deal was structured on historical driven fair market value. Increased revenues increase value of business going forward.

Vendor Risk:
Vendor side has to identify primary areas of risk and properly support them in the Purchase & Sale Agreement.

  1. What if the new ownership exercise control and decides to focus on other targets and ties up company resources impairing the Vendor in achieving their priorities.  As illogical as that sounds it does happen.

  2. While the Vendor may not have total decision making authority after cashing the Buyers cheque, the Vendor is the expert in what it takes for the business to achieve results. How do you manage who has operational control, how is control managed, and for how long?

  3. Some products and services may take longer than a fiscal year to initiate, complete, and provide. How do you build a cumulative target for a length of time that is fair to both parties?  E.g.: While earn out is paid annually for term of agreement if target missed one year the results for the term can be calculated on a cumulative basis allowing full payment of the agreed amount if the total targets are achieved for the full term of the earn out.

  4. Or, the case where if the target is missed by $1 does that mean a zero payment? The all or none case becomes a poisonous issue if some of the reason for not quite getting there relates to point 1 and/or 2. Is the Buyer an obstacle to the Vendor’s success? Or what if the market is down for no reason of the business? Anticipating flexibility while structuring the agreement supports a long term healthy relationship.

  5. While business models vary, is the fairest model structured on a portion of benchmark targets including some form of incentive calculation or bonus structure? The Vendor’s primary goal is the achievement of additional payments. The Buyer’s primary goal is achievement of a higher rate of return. This requires establishing some type of stepped calculation e.g.: 20% less than target receives modest payment prorated to some form of payment (or bonus) schedule.

Earn outs typically reflect future opportunities and rely on the status quo to be achieved. The modeling for individual business structures requires intelligent recognition of market ups and downs, personalities, and fair outcomes. 

Tuesday, March 19, 2013

How Does MAXIMA Maximize Value?

There are many reasons to use a M&A intermediary such as MAXIMA to sell your business. The number one reason sellers engage MAXIMA is they believe we can maximize the value their business will transact at.  I would like to review the some of the processes that we use at MAXIMA to maximize the value owners receive for their business.

We start by preparing an independent fair market value of the intrinsic value of the company. Warren Buffet is famous for saying that “Price is what you pay, value is what you get”. A valuation cannot determine what price your company will receive on the open market. The valuation allows us to understand the business model, value drivers of the business, and to set a baseline price that the owner is prepared to accept. The value drivers will assist the business owner in knowing what factors to focus on to increase the value of the business, and provides the intermediary with the tools to effectively market the business.

The key for value maximization is to conduct an auction format with the greatest number of participants. To recruit the widest range of potential buyers MAXIMA does not limit our searches by type of buyer, industry segment, or geographic scope. 75% of the time the seller was not aware of the identity of the buyer prior to the transaction.  

Transactions are rarely completed with 100% of the cash due on close. The seller typically wants the maximum of cash up front, and buyers generally want to defer the payment through an earn out or a vendor financing arrangement. We negotiate on behalf of the vendors to ensure they are compensated for any time value of money, or risk associated with any payment that is deferred. The realized value for the business can be maximized when the vendor has the flexibility to consider payment in the form of stock, royalties, earnouts, options, lease agreements, or management contracts. Management continuity is typically required for 12-24 months from close.

To successfully execute a transaction for privately held businesses requires a fulltime commitment to the process. As a result of the required time commitment it is advisable for business owners to focus on operating their business as if they had no plans to sell it for the next 24-36 months. The same MAXIMA project consultant who conducted the initial valuation, contacted the potential buyers, negotiated and structured the transaction will be assigned to your project right up to the cheque exchange. Engaging a professional intermediary will allow the business owner to maintain or increase the value of the business through what can be a 6-24 month process. MAXIMA will assign a professional that is dedicated to work with you from start to finish.

George Pinder, CMA

Monday, March 4, 2013

The Hierarchy of Recurring Revenue

How to make your company irresistible to potential buyers

One of the biggest factors in determining the value of your company is the extent to which an acquirer can see where your sales will come from in the future. If you’re in a business that starts from scratch each month, the value of your company will be lower than if you can demonstrate the source or sources of your future revenue.  A recurring revenue stream acts like a powerful pair of binoculars for you – and your potential acquirer – to see months or years into the future; creating an annuity stream is the best way to increase the desirability and value of your company. 

The surer your future revenue is, the higher the value the market will place on your business. Here is the hierarchy of recurring revenue presented from least to most valuable in the eyes of an acquirer.

No. 6: Consumables (e.g., shampoo, toothpaste)
These are disposable items that customers purchase regularly, but they have no particular motivation to repurchase from one seller or to be brand loyal.

No. 5: Sunk-money consumables (e.g., razor blades)
This is where the customer first makes an investment in a platform. For example, once you buy a razor you have a vested interest in buying compatible blades.

No. 4: Renewable subscriptions (e.g., magazines)
Typically, subscriptions are paid for in advance, creating a positive cash-flow cycle.

No. 3: Sunk-money renewable subscriptions (e.g., the Bloomberg Terminal)
Traders and money managers swear by their Bloomberg Terminal; and they have to first buy or lease the terminal in order to subscribe to Bloomberg’s financial information.

No. 2: Automatic-renewal subscriptions (e.g., document storage)
When you store documents with Iron Mountain, you are automatically charged a fee each month as long as you continue to use the service.

No. 1: Contracts (e.g., wireless phones)
As much as we may despise being tied to them, wireless companies have mastered the art of recurring revenue. Many give customers free phones if they lock into a two or three-year contract.

When you put your business up for sale, you’re selling the future, not just the present. So if you don’t have a recurring revenue stream, consider how best to create one, given your type of business. It will increase the predictability of your revenue, the value of your business, and the interest of potential acquirers as they look to the future.


Wondering if you have a sellable business? Contact the MAXIMA Group for a consultation. We focus on privately held companies with annual revenues of $3 million to $60 million. We also advise larger public and private companies on buy-side engagements.