The Verit View – October 2014
Verit Advisors’ view is that transaction consideration, i.e., the amount an owner receives when selling his or her business, is not always as it seems. Why? Because in many transactions – if not most – some of that consideration is not paid at closing, but rather is held in escrow and/or as an earn-out, the sum of which can approach 5% – 45% of total proceeds. Understanding, negotiating, and structuring these deferred payments is a critically important aspect of optimizing a seller’s transition strategy. Here’s a simple rule of thumb: Cash at close = Negotiated equity price less escrows less earn-outs.
While many private business owners take offense to the notion, buyers are rarely prepared to take a seller’s word for it when it comes to the status of the company being acquired. Even after conducting extensive due diligence, most buyers will ask the seller to defer the receipt of some of the purchase price for a period of time, often a year or more. Such holdbacks, however, have declined as a percentage of total enterprise value (“TEV”) during the first half of 2014, according to GF Data, which obtains information from private equity firms and other financial buyers reporting on transactions they complete. In the first half of 2014, escrow holdbacks averaged 6.4% of TEV, down from 7.2% in 2010.
Unlike indemnification escrows, which are more or less a given when selling privately held businesses, earn-outs are not necessarily part of every deal. Earn-outs represent additional payments to which an owner will be entitled post-closing should certain milestones be achieved. They represent a bridge, of sorts, between a seller’s valuation expectations and a buyer’s reluctance to pay a high price today for tomorrow’s growth potential. One of the problems with earn-outs, however, is defining and measuring those milestones. Another problem (from the seller’s perspective at least) is that they are getting larger and lasting longer, in contrast to indemnification escrows. According to SRS/Acquiom, a firm that manages escrow and other post-closing arrangements, in 2013 earn-outs represented 40% of potential deal proceeds (for transactions that included earn-outs), up from 23% three years earlier. Moreover, earn-outs are lasting longer, with a shift from one-year holdbacks to increasing use of two- and three-year holdbacks. The good news? So far this year only 27% of completed transactions included an earn-out provision, down from 39% in 2011 (according to J.P. Morgan in its 2014 M&A Escrow Study).
So what is the business owner who is interested in selling his or her company to do? In our opinion there are three concepts that maximize the seller’s negotiating leverage. First, if the decision has been made to sell the business, hire an experienced intermediary to facilitate a competitive process. The negotiation of escrows and earn-outs typically happens after the presumptive buyer has been identified. Be sure the buyer understands there are many other qualified runners-up more than happy to step in should negotiations turn sour. Second, consider selling the business to the company’s employees. Selling to an employee stock ownership plan (“ESOP”) can often bring the best offer because of the significant tax savings involved. Also, ESOPs are an excellent way to avoid earn-out and other post-closing disputes. Many business owners sell a partial stake to an ESOP, stick around to run the business, and remain controlling shareholders. With all that skin in the game, no need to use an earn-out. And when selling the entire company, it is typical that the management team remains in place. They are intimately familiar with the business and its prospects, and likely have a higher level of trust in their soon-to-be-former boss, thereby reducing the need for an earn-out or other post-closing purchase price adjustments. And third, seriously consider a dual-track process, whereby an ESOP is integrated into the M&A process as a potential buyer. Such a “stalking-horse” bidder effectively guarantees a seller a fully informed decision when it comes time to decide which route to take, outsiders or employees.
As always it is Verit’s vision to bring a fresh approach and customized solutions to advise private business owners on ownership transition.