M&A What Lever Do I pull
By Tom Zucker,
Imagine you have spent years preparing yourself and your business to be ready to transition to your employees or to an outside buyer, and you are now faced with the daunting task of deciding how to orchestrate the sell process. As you enter this new arena, you quickly realize that your inventory logistics, cash flow management and general business acumen have little value in this new game. The game is filled with unfamiliar terms such as earn outs, equity hold backs, normalized EBITDA and many others. You painfully realize that the stakes of this new game are significant to you and your family, and that the sell of your business is probably the biggest economic event of your life.
This familiar scene occurs to almost every business owner after deciding to sell. The primary desire of most business owners is to gain clarity of options, and subsequently have executed a successful transition that provides them the time and monetary freedom that they desire. Clearly an advisor or an advisory team is essential at this stage of your business to achieve the desired outcome. It is critical that business owners surround themselves with advisors that will clarify rather than complicate these options. The selling process in its entirety is very complex, but if broken down into smaller steps, the steps are actually logical and understandable.
A good example of this simplification is the decisions or “levers” needed to determine how you will get paid the purchase price. Purchase price can come in a variety of forms including cash, other company stock, notes, earn outs and many others. Almost everyone will agree that cash at closing is the most desired outcome. Unfortunately due to future company cash flows, bank financing or buyer’s equity limitations the ability to pay for the purchase price in cash is not always possible. Many investment bankers advise owners to be open minded to a variety of structures and options to determine if a higher purchase price adequately offsets the level of risk within the proposed structure. Often these “levers” move in opposite directions.
The following is a brief summary of the most common “levers” involved in the structuring of deals and transaction:
An earn out is designed to satisfy the seller’s desire to receive full value for future anticipated economic performance tomorrow. A buyer will often propose this structure when a customer concentration exists or future growth in a new or current customer is believed to be likely by the seller. A recent buyer summarized his perspective of an earn out as “I would be happy to pay the seller his desired price as long as the revenue and cash flows occur”. The biggest risk to a seller is that the new buyer may not properly run and maintain the business. The more uncertain an owner is about the new buyers ability to perform, the higher on the income statement the earn out will be based (i.e. revenue or gross margin). Earn outs are typically based on revenue or margin numbers, but any variety of metrics, financial or non-financial, can be set as “hurdles” for the payment of an earn out. Earn out payments typically range from two to five years based on the value that needs to be earned in an earn out structure.
A seller note is another common deal structure that enables a higher price to be paid by the buyer. Most buyers try to minimize the equity invested in a business purchase to achieve higher rates of return on investment, save capital for additional purchases, or because of capital resource constraints. In 2002, many deals were completed that required seller notes due to the tight bank lending environment. While the assets and the cash flows of the business warranted higher purchase prices, the lack of debt financing and equity return expectations caused a value gap between sellers and buyers. Collateral is often available to secure the seller note, but typically in a subordinated position to the new senior bank.
It is not uncommon to have a combination of seller notes and earn outs in a deal to enhance the cash purchase price.
An equity hold-back is the retention of equity ownership in the business along with the new buyer. The biggest risk that a new buyer has is the ability to transfer customers, retain employees and to enable a business to function in the absence of the previous owner. Many deals utilize equity hold backs to protect against the loss of the previous owner. Often an equity hold back will be accompanied with an employment contract for the previous owner. The seller would retain equity in the business. This structure is particularly attractive for a private equity firm that desires to make an investment and exit the investment within a five year window. Typically equity hold-backs are in the 10-20% range.
As an owner begins to pull the “levers” involved with the decision to sell, preparation and awareness are essential. The awareness of the levers available to an owner can propel you to a life of freedom, or back to rebuilding the business.