M&A: What Lever Do I Pull?
By Tom Zucker, EdgePoint Capital Advisors
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:
Earn-Outs: 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.
Seller Notes: 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.
Equity Hold-back: 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.
© Copyrighted by Tom Zucker, President of EdgePoint Capital Advisors, merger & acquisition
advisors. Tom can be reached at 216-831-2430 or on the web at www.edgepoint.com.