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Article added or updated:
09/05/2011 |
SELLING YOUR TECHNOLOGY COMPANY -
WHY EARNOUTS MAKE SENSE TODAY
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06/08/05
By David M. Kauppi, CBI, President Mid Market Capital
Related Artcles:
Buying a Business
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Acquisition
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Maximize Business Value
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Sell Your Business
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 not only can facilitate the 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.
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| 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 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 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 the 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 the seller is willing to take on
some of that risk in the 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
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.
4. An old businessprofessor 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 1000. Six %
of this new revenue stream will far surpass 100% of the old one.
5. 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
sales 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 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 the currency of choice for acquisitions. Their preferred currency is
cash. By agreeing to an earnout, you give the buyer’s cash more velocity
(ability to make more acquisitions with their cash) and therefore become
a more attractive candidate with the ability to ask for greater
compensation in the future.
7. The market is starting to turn positive which reawakens sellers’
dreams of bubble type multiples. The buyers are looking back to the
historical norm or pre-bubble pricing. The seller believes that this
market deserves a premium and the buyers have raised their standards
thus hindering negotiations. An earnout is a way to break this impasse.
The seller moves the total selling price up. The buyer stays within
their guidelines while potentially paying for the earnout premium with
dollars that are the result of additional earnings from the new
acquisition.
8. The improving market provides both the seller and the buyer growth
leverage. When negotiating the earnout component, buyers will be very
generous in future compensation if the acquired company exceeds their
projections. Projections that look very aggressive for the seller with
their pre-merger resources, suddenly become quite attainable as part of
a new company entering a period of growth. An example might look like
this: Oracle acquires a small software Company B that has developed
Oracle conversion and integration software tools. Last year Company B
had sales of $8 million and EBITDA of $1 million. Company B had grown by
20% per year. The purchase transaction was structured to provide Company
B $8 million of Oracle stock and $2 million cash at close plus an
earnout that would pay Company B a % of $1 million a year for the next 3
years based on their achieving a 30% compound growth rate in sales. If
Company B hit sales of $10.4, $13.52, and $17.58 million respectively
for the next 3 years, they would collect another $3 million in
transaction value. The seller now expands his client base from 200 to
100,000 installed accounts and his sales force from 4 to 5,000. Those
targets should be very easy to hit. If these targets are met, the buyer
easily finances the earnout with extra profit.
9. The window of opportunity in the technology area opens and closes
very quickly. An earnout structure can allow both the buyer and seller
to benefit. If the smaller company has developed a winning technology,
they usually have a short period of time to establish a lead in the
market. If they are addressing a compelling technology gap, the odds are
that companies both large and small are developing their own solution
simultaneously. The seller wants to develop the potential of the product
and achieve sales numbers to drive up the company’s selling price. They
do not have the distribution channels, the resources, or time to compete
with a larger company with a similar solution looking to establish the
industry standard. A larger acquiring company recognizes this first
mover advantage and is willing to pay a buy versus build premium to
reduce their time to market. The seller wants a large premium while the
buyer is not willing to pay full value for projections with stock and
cash at close. The solution: an earnout for the seller that handsomely
rewards him for meeting those projections. He gets the resources and
distribution capability of the buyer so the product can reach standard
setting critical mass before another large company can knock it off. The
buyer gets to market quicker and achieves first mover advantage while
incurring only a portion of the risk of new product development and
introduction.
10. You never can forget about taxes. Earnouts provide a vehicle to
defer and reduce the seller’s tax liability. Be sure to discuss your
potential deal structure and tax consequences with your advisors before
final negotiations begin. A properly structured earnout could save you
significant tax dollars.
Smaller technology companies have many characteristics that make them
good candidates for earnouts in sale transactions: 1. High growth rates,
2. Earnings not supportive of maximum valuations, 3. Limited window of
opportunity to achieve meaningful market penetration, 4. Buyers less
willing to pay for future potential entirely at the sale closing and 5.
A valuation expectation far greater than those supported by the buyers.
It really comes down to how confident the seller is in the performance
of his company in the post sale environment. If the earnout targets are
reasonably attainable and the earnout compensates him for the at risk
portion of transaction value, a seller can significantly improve the
likelihood of a sale closing and the transaction value.
David Kauppi is the president of Mid Market
Capital, Inc. MMC is a private investment banking and businessbroker
firm specializing in providing corporate finance and intermediary
services to entrepreneurs and middle market corporate clients in high
tech and a variety of industries. Dave began his high tech Mergers and
Acquisitions practice after a twenty-year career within the information
technology industry. Dave is a Certified Business Intermediary
(CBI), a licensed businessbroker, and a member of IBBA (International
Business Brokers Association) and the MBBI (Midwest Business Brokers and
Intermediaries). For more information or a free consultation please
contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com
or visit our Web page
www.midmarkcap.com
Related Artcles:
Buying a Business
Company Website Value
Strategic
Acquisition
Selling Tech Company
Maximize Business Value
Selling Your Business
Sell Your Business
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