11 Reasons to Use Earnouts in the Sale of Your Company (Part 1)
Here are the first six of 11 reasons earnouts should be considered when selling your technology (or other) company.
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, private equity 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.