An earn-out is a means of leaving the ultimate price that a buyer will pay for a business, in part, down to the future performance of that business. In other words, not making it only a function of your estimated Future Net Maintainable Earnings (FNME) and an industry applicable multiple. So with the rule of thumb method, we might have determined that the FNME was R10 Million, and the most appropriate multiple was, say, six — hence the value was R60 million.
In an earn-out, there are two additional factors. First, despite every assurance from the seller that future profits will evolve as shown in his FNME calculation, the buyer would prefer to derisk his purchase by asking the seller to put his money where his mouth is.
In other words, he wants some of the purchase price he is prepared to pay to be dependent on future profits earned, not just promised.
Second, despite having arrived at a reasonable estimate of his FNME, the seller might feel that this number averages out his future earnings potential rather than showing how actual profits might really accelerate in, say, years two, three or four — and which the FNME calculation will have discounted given their distance into the future.
Related: Principles in Business Valuations
The agreed solution to the buyer’s reluctance for risk and the seller’s bullish assessment of his company’s future, is to structure a deal where part of the price is paid now, and the balance is based on future performance.
An Earn-Out In Practice
Imagine a company that had net profits after tax of R6 million last year, will make R9 million this year, is predicting R12 million next year, and then R16 million the year after that.
Through a weighted average process, both buyer and seller have agreed that the likely FNME for the business is R10 million — i.e. applying most weight to the current and subsequent year, while looking back in time to check the profit history, and believing some of the future promises for profits from the forecasts provided. When structuring the deal, buyer and seller agree that they can do better through an earn-out structure.
A simple earn-out might therefore be structured by the buyer as follows:
- Current net profit before tax (R9m) x multiple (6) x 50% = R27 million
- Year 2 net profit before tax (R12m) x multiple (6) x 25% = R18 million
- Year 3 net profit before tax (R16m) x multiple (6) x 25% = R24 million
- Total consideration = R69 million
Flexibility, Penalties And Incentives
You might well ask whether receiving R69 million spread over three years is in fact any better than receiving an up-front payment of R60 million. There is little to choose between them. But this is where the flexibility of the earn-out, and its complications, now come into play.
The first change that buyers might offer, or sellers demand, is a variable multiple relative to performance. The buyer can lay down a challenge to a vendor by saying that, if you really think you can get from R9 million this year to R16 million in year three, then I will incentivise you to do so by raising the multiple from six to seven.
But, by the same token, if things do not go as well as you predict, I want to cover the risk that I have overpaid in years one and two, and hence if your year three earnings are below R12 million, the multiple falls to five.
As you can see, the permutations for adjusting the earn-out through the percentage paid up-front, the relative splits of consideration between years one, two and three, the length of the earn-out, the variations in the multiple to be applied, are legion.
And, if this was not enough, there are also the regular inclusions of caps (maximum levels the buyer will pay at each stage of the earn-out regardless of profit performance) and collars (amounts below which the consideration cannot fall regardless of how badly the seller performs) to provide upside and downside protection for each.
Other nuances might include the split between cash or shares offered as consideration (if a listed buyer) — in fact the list of variations is almost endless. And this is where the principal problem with earn-outs comes in.
Related: How Saleable Is Your Business?
Buyer And Seller Behaviour
For an earn-out to work, the seller needs to be largely left to their own devices throughout the term of the earn-out to achieve the profit targets that have been set so that they can maximise their outcome. Any interference from the buyer could be construed by the vendor as detrimentally affecting the consideration that could be earned in each year.
From the buyer’s side, this kind of vendor behaviour can be equally problematic. Armed with the knowledge that each rand NOT spent on, say, R&D or marketing actually increases the earn-out, the vendor is unlikely to make an investment in the future of a company in which he will play no part. The buyer’s inclination, therefore, is to get involved where he can to moderate such behaviour.
The only way to ensure that an earn-out can work, therefore, is for the purchase and sale agreement to have a comprehensive and detailed list of rules and regulations for both buyer and seller, with remedies and adjustments if these are breached.
It should be noted that not every action by a buyer is always detrimental to the performance of the company during its earn-out, and more often than not the buyer will provide working capital, admin support and introductions to new markets to increase sales, in an effort to grow the business for the future. So some adjustments to the earn-out are actually put in place to discount the benefits that these actions unduly bring to the seller, as the buyer does not want to be penalised by paying more for the enhancements that he has brought to the business.
Choosing The Right Deal Structure
Earn-outs are complicated beasts. Far too often buyers and sellers go wading into complex formulae with rules, incentives and penalties with the naïve belief that all can be applied seamlessly throughout, say, a three year term.
To protect their position, vendors can demand ever more complicated protections (such as the staged acquisition of their shares as opposed to a pure split of consideration) in the hopeful belief that a better structure leaves them with more power until the last payment is made.
From the buyer’s side, now that they have bought their shiny new toy, more often than not the temptation to start playing with it is just too great, and they will be frustrated that they cannot bring their own resources to bear.
On the one hand they want the vendor to behave with a longer-term future in mind, and on the other they want to enhance the performance of their purchase but not allow the seller to benefit from this.
Despite all of the complications and frustrations, earn-outs remain enduringly popular, with no two structures ever looking exactly the same.
Vendors are just too tempted by the opportunity to really cash-out when their business will be ‘flying’ in two or three years’ time to worry about the inherent complexities that may frustrate such an outcome. Buyers are keen to incentivise owners to achieve these stellar profits, and will pay for them, but at the same time are desperate to cover their downside should these targets not be achieved.
Aside from their popularity I would guess that at least 50% of all earn-outs end in tears, with the preferred remedy being a buy-out at an agreed lump sum for the balance of the earn-out, and with both parties ultimately going their separate ways.
This may not be a bad outcome for either party, but does somewhat call into question the benefits for either party of entering into such an inherently unstable deal structure in the first place.
How To Increase Profits By Focusing On The Needs Of Customers
How a water softener company boosted sales with moves as simple as changing its ecommerce platform and hiring an AdWords advisor.
“Growing a small business is hard. If it were easy, everyone would have a business,” says Tom Tarasiuk, who knows first-hand the difficulties that small businesses go through when they try to succeed at online marketing.
As president and owner of Discount Water Softeners, Tarasiuk has helped his company streamline its efforts to provide an outstanding user experience and increase sales. This undeviating focus on the customer and a willingness to take risks have enabled the business to grow.
Here are those all-important strategies he’s used:
Customer-centric product development
Tarasiuk says that a key tactic in his company’s growth has been the work by leadership to keep overhead costs low. One way that’s been done is by eliminating the usual middle men and purchasing water systems directly from the manufacturer.
But even more important has been the company’s customer-focused philosophy. The company keeps its overall inventory minimal and develops products and features that will meet the needs of its clients. It’s done this by avoiding stocking merchandise that won’t sell because people don’t need it.
As Tarasiuk told me: “Happy customers are a critical part of our growth. We base our additional or new products on what customers are requesting or what areas of the market need a void filled.”
Improving the user experience
The company’s emphasis on the customer plays out in its online marketing strategy. Case in point is when managers decided in 2013 to switch ecommerce platforms. They had been using Volusion and transitioned to Magento.
Tarasiuk says they wanted a framework that would allow them to customize various types of content (images, videos, etc.) on any of their pages. Their goal was to improve the user experience and increase conversions. They did have some concerns about the switch, he says. They feared Magento would be less user-friendly on the back end. But without taking risks, an organisation cannot grow. The result? After changing to Magento, the company’s sales nearly doubled.
And it saw its organic SEO increase noticeably with almost no additional effort. At that time, the company completely redesigned its website. Again, prioritising the customer was key. The location of optional items and upgrades on the site was improved, for instance.
This allowed customers, Tarasiuk says, to “customise their orders and learn what upgrades would benefit them the most for their needs.” The site redesign, he says, increased company sales by as much as 15 percent.
Saving time with email
Another major part of refining the user experience and cutting costs at Discount Water Softeners entailed enabling customers to resolve some of their issues through email instead of over the phone. At one point, customer service reps were taking 45 minutes to handle each call that came through. Tarasiuk says he didn’t have enough employees to handle the volume of the calls. And hiring more workers would mean increasing overhead costs.
Instead, he solved the problem by allowing people to ask their most common questions through email. Through Magento, the company added PHP forms for people to fill out and used Crazy Egg to determine the best places on the site to put the forms. The company also increased sales by driving traffic to the forms by using Google AdWords. This solution cut, by 30 minutes, the time that its reps spent on each call, Tarasiuk says. It allowed the reps to handle a higher volume of calls without adding more employees.
Google AdWords has been crucial to growth.
Google AdWords has been crucial to the growth of Discount Water Softeners. In fact, Tarasiuk goes so so far as to call AdWords “essential to efficient performance and high ROI for sales.” He says he believes every company should have someone who is skilled at leveraging AdWords to its full potential.
Tarasiuk’s business has been using Google AdWords for over 10 years, and he describes learning how to leverage this tool as “pivotal in our growth.”
When the company first started using AdWords, it wasn’t selling much and was spending only $20 per day on the tool. But then Tarasiuk found Gail Gardner, an AdWords advisor teaching pay per click strategies at the now-defunct SearchEngineForums, and the situation changed. The advisor told him that if he wanted his company to be “discovered,” he should be spending at least $70 to $80 on AdWords per day.
Following that advice, Tarsiuk says, has revolutionized his company’s online presence and has been a decision he’s never regretted. At one point, when Gardner changed her work and switched to managing PPC accounts, the company had to go without an advisor for a period and instead rely on Google support. That situation wasn’t ideal because it wasn’t clear whether Google was prioritising the company’s campaigns or focusing on its own interests, Tarasiuk says.
Google did help keep Discount Water Softeners going, but it also didn’t see a marked improvement in its campaigns at the time. The assistance of an advisor was what really made a difference in itsprofits. So Tarasiuk contacted Gardner and asked for a recommendation for a new AdWords manager.
“That original AdWords advisor was essential at not only jump-starting our internet presence, [but] she showed us how to use and manage AdWords,” he says.
While there is no formula for growing a business successfully, there are principles that can guide you along that way. Take smart risks, and make your decisions based on what will help your customers. Because of the time and money Discount Water Softeners saved on strategies it adopted, it has been able to use the extra resources it gained to launch a new line of high-efficiency water softeners.
The company has also been able to diversify its merchandise, improve its product and benefit the environment, Tarasiuk says.
“You miss 100 percent of the shots you do not take,” he says, quoting hockey star Wayne Gretzky.
This doesn’t mean you should be reckless. It means to get good advice, and then take a leap of faith based on that information. If you don’t, you’ll never know what you could be missing.
This article was originally posted here on Entrepreneur.com.
Why Mitigating Your Risk Can Drive Up Your Fleets Profits
Business naturally comes with risk. How you mitigate that risk could mean the difference between a sustainable, profitable enterprise and a business surviving on the edge. Here’s how fleet management companies handle their risk.
“Whether your fleet consists of ten vehicles or 1 000 plus, it always boils down to the cost of maintenance, fuel and cost-efficient routes,” said Dr David Molapo, head of fleet management, vehicle and asset finance at Standard Bank, at a round table event hosted by Standard Bank to determine key impacts on profitability and growth in the fleet management industry.
To keep costs down and profits up, focus on:
- Mitigating fuel costs for business growth
- Implementing tools and telematics to save on transport and fleet spend
- Training and monitoring drivers to ensure driver and load safety
- Mitigating risks such as hijacking, driver behaviour and delivery delays
- Bringing services in-house
- Complying with legislation.
Attracting and training quality drivers
Attracting quality drivers is one of the industry’s main challenges. Businesses often have to recruit drivers and upskill them to become quality, reliable drivers.
“SAB has a programme where a driver will be sourced and run on a SAB truck for a year to 18 months,” says Con Conradie, country commodity manager: Fleet for SABMiller.
“He is assessed over a long period and once he meets the grade he can buy his own truck and receive a ten year contract.”
“We place our drivers on advanced driving courses and all our drivers are allocated to a specific vehicle, which has reduced our insurance costs,” says Dorin Charalambous, MD of DSC Transport.
Preparing for the risks
“We have branded our reps’ vehicles with a full body wrap,” says CEO of Nature’s Choice, Greshan Mandy. “Since then we have not had a single case of theft. It’s advertising for your business as well as an immediate deterrent.”
“We contracted with Driver Check to monitor our fleet and their behaviour on the road,” says Mandy.
“We also have cameras in the vehicle to watch the vehicle and the driver,” he adds.
“These can deter the drivers from driving recklessly. If your driver has not done anything wrong the camera can prove his innocence,” says Reinard Basson, financial manager for Shoprite Group Transrite National.
Delays in delivery
“A truck is scheduled to do a certain route and that whole route has been timed, from the moment it leaves the depot, when it stops at an outlet and the time it takes to offload,” says Conradie. “Each vehicle has a slot at the outlets and the vehicles have mechanised forklifts. We levelled the pavements and widened the doors at our outlets so that there would be no delays,” says Conradie.
“Sometimes we deliver palletised goods and the next day it is a delivery of cement bags. Often there is no one to assist with the offload, which results in delays while you wait for assistance,” says Hennie Engelbrecht, director of Kopano Fuel.
The need for specialist services
Transporting for niche industries is in demand, with specialist transport services required for niche products.
“Cost is important to us but delivering the product the way we want it delivered is also key,” says Carel Ganger, financial director for Ceva Animal Health. “We’re transporting a high value product and there’s a need in the transport industry to do something specific for cold chain.”
Bringing services in-house
“We used to use sub-contractors to get our product to the market as quickly as possible. Courier costs were becoming exorbitant and we were being impacted by the labour strikes in the transport industry,” says Mandy.
“We made a decision to bring transport in-house and we are now saving around R300 000 per month.”
Complying with legislation
“Our legislation and regulations are changing and many municipalities across the country are taking pride in maintaining their road infrastructures and ensuring that vehicles carrying abnormal loads have the right permits in place. This is beneficial to the industry,” says CEO of Matalana Transport, Comfort Padi.
“Customers are also ensuring that suppliers become compliant with the current legislations, such as ensuring that transport suppliers are ISO 9001 accredited and compliant.”
How To Maximise Real Returns For Your Shareholders
When you are both a shareholder and a manager of a company, it is all too easy to forget that, as a director, you have a responsibility to deliver returns and create value for your shareholders.
When you sit as a director on the board, you have to apply your mind to how the board and the wider team will deliver on the expectations that shareholders have or should have of the business.
There are many ways that directors can create tangible and meaningful value for shareholders and other stakeholders. Just having an effective governance process creates shareholder value. However, as a director here are some specific ways you can drive shareholder value creation.
Watch out for the illusion of success
When you are involved in day-to-day operations, it is so easy to fall into the trap of seeing all the good work that your team is doing as the reason to justify why shareholders are not getting the returns they should. In one of our companies, a shareholder once commented that ‘nothing seemed to be going on’.
I was initially taken aback and, as the excuse was about to pop out my mouth, I realised that he was right. If a shareholder does not get their return or some form of increase in value, then there is ‘nothing going on’ for them. When you wear your director hat in a boardroom, then understanding, agreeing and meeting shareholder expectations is a key area of focus.
Wear the ‘three hats’ well
As a shareholder-manager who also serves as a director on the board, you have to learn how to put aside your shareholder and manager hats and instead wear only your director hat. We have observed that the ability to wear the right ‘hat’ at the right time creates massive value for the board and the company as a whole.
Shareholder issues simply do not belong in the boardroom. They cloud effective decision-making and can, ultimately and ironically, destroy shareholder value even if the majority of those present are shareholders.
Independent directors are therefore pivotal in keeping everyone focused on just wearing the director hat well.
Turn risks into opportunities
Risk is inherent in every aspect of being in business. We cannot escape it, yet we can learn to mitigate the likely risks we face. Directors on a board should take this one step further – by finding ways of turning risks into opportunities. Perhaps a key risk for you is the availability of qualified and experienced employees.
A board might look at this risk and see the opportunity inherent in establishing a learning academy as a means of taking control over the quality and availability of critical human capital, which could even become an additional profit generating business in the short-term to medium-term.
Learn how to identify the right opportunities
Entrepreneurs tend to excel at drumming up new ideas and opportunities, yet they struggle to choose the right opportunities in the context of limited time and resources. The board of an SME or privately-held company adds value to shareholders by establishing a framework to separate the ‘wheat from the chaff’.
This accelerates the growth in value by choosing the right path at the right time and keeping the entrepreneur ‘on track’.
Never underestimate organisational culture
As Peter Drucker says, “Culture eats strategy for breakfast.” The best business model and strategy can all be for nought if the culture of the company is toxic or undermines the promise of the enterprise.
Directors on a board should never underestimate the importance of the collective values and behaviours of its team and how this directly enhances or destroys shareholder value.
Address the ‘elephant in the room’
And lastly, SMEs and privately-held companies are renowned for avoiding the tough conversations at a board or executive level, especially when there are personal relationships between shareholder-managers.
In wearing the director hat well, supported by candid independent directors, massive value can be quickly unlocked through decisively acting on the long-unaddressed issues that drain all the energy out of the team.
In short, directors have an absolute role in ensuring value creation for shareholders. However, this does not happen by accident, it happens by design. Have you designed your board to achieve this?
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