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
acquired entity and are tied to measurable economic milestones such as revenues, gross profit, net income and EBITDA. An intelligently structured earnout not only can facilitate closing of a deal, but can be a win for both buyer and seller. Below are ten reasons earnouts should be considered as part of your selling transaction structure.1.Buyers acquisition multiples are at pre 1992 levels. Strategic corporate buyers, private equity groups, and venture capital firms got burned on valuations. Between 1995 and 2001 premiums paid by corporate buyers in 61% of transactions were greater than economic gains. In other words, buyer suffered from dilution. During 2002 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.
2.Based on bubble, there is a great deal of investor skepticism. They no longer take for granted integration synergies and are weary about cultural clashes, unexpected costs, logistical problems and when their investment becomes accretive. If seller is willing to take on some of that risk in form of an earnout based on integrated performance, he will be offered a more attractive package (only if realistic targets are set and met).
3.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 seller is willing to take on a portion of post closing performance risk. The key stakeholders of seller have an incentive to stay on to make their earnout come to fruition, a situation all buyers desire.
4.An old business professor once asked, “What would you rather have, all of a grape or part of a watermelon?” The spirit of 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 1000. Six % of this new revenue stream will far surpass 100% of old one.
5.How many of you have heard of thrill of victory and 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 stock. Lets say that resultant sales proceeds were 160,000 shares totaling $8 million in value. Company A’s stock goes on a steady decline and by time you can sell, price is $2.50. Now 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 next 3 years if revenue targets for your division are met. Your minimum guaranteed multiple is 9.38 x with an upside of 18.75x.
6.Strategic corporate buyers are reluctant to use their devalued stock as currency of choice for acquisitions. Their preferred currency is cash. By agreeing to an earnout, you give buyer’s cash more velocity (ability to make more acquisitions with their cash) and therefore become a more attractive candidate with ability to ask for greater compensation in future.
7.The market is starting to turn positive which reawakens sellers’ dreams of bubble type multiples. The buyers are looking back to historical norm or pre-bubble pricing. The seller believes that this market deserves a premium and buyers have raised their standards thus hindering negotiations. An earnout is a way to break this impasse. The seller moves total selling price up. The buyer stays within their guidelines while potentially paying for earnout premium with dollars that are result of additional earnings from new acquisition.
