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.
If You Want Scale, Fail Fast And Learn Quickly
Mindset, focus and an understanding of scale are essential if you want to build a highly profitable, growing business.
“The secret to scaling a business is increasing revenues without incurring a corresponding increase in operating costs,” says Tom Asacker, author of The Business of Belief, Opportunity Screams, A Little Less Conversation and A Clear Eye for Branding, all groundbreaking books that redefine business and communication for the new age of abundance. “The single most important challenge is to have a deep understanding of your value creation and customer attraction and retention process, as well as how the company will ultimately make money over time through the unique realisation of that process.”
According to Howard Sackstein, founder of Saicom Voice Services, scale used to be measured by the number of people you employed or the number of branches you opened. “Today, these questions have become irrelevant,” he says.
“When Whatsapp was sold for $19 billion the business had only 55 employees servicing 450 million users who were sending 34 billion messages a day – that’s a tiny company with enormous scale. So, today scale has come to mean something very different. In the new economy, scale is about scalable technology, how do we build software and apps that can cater for a billion users? The ideas of lots of employees and lots of offices has become old fashioned.”
The problem is that scale comes with costs and that’s why money is often the enemy of entrepreneurship. “Many of the great businesses of the new economy all began in garages, a small group of people, each with real skills each trying to bootstrap an idea to see if it worked,” continues Howard.
“Often people go looking for funding; there’s a problem there too though – they scale too fast once they receive the cash and ultimately they fail because they have too much money. Entrepreneurs need to start small and if they fail they must fail fast. They need to test the market and grow incrementally to prove their idea. Once the idea has achieved a degree of adoption and has ‘crossed the chasm’ of technology adoption, only then can you start thinking of scale. And today scale means few costs, few employees, and tech that can scale to a mass market.”
Your Mindset is Everything
Your mindset while scaling is critical. “Value creation, customer attraction and your retention process are the result of every decision you make as an entrepreneur,” says Tom. “Your mindset shapes how you make these decisions.
“Every rand spent should be to add value in the eyes of the customer, or to improve the process that delivers that value, through automation, distribution, channel partners and so on.
“If businesses aren’t hyper-focused on adding value and deepening relationships with customers, someone will come along who will. If that happens, whether or not that process produces rapid growth is beside the point.”
Howard believes that follow-through is also essential. “So many people really want to build empires,” he says. “But how do you measure your success? Is it the number of employees you have, the number of companies, your disruptive influence on the market, revenue or actual profitability?
“You really need to decide this up front and that will affect your strategy. I probably have an old school mentality, but for me profit is everything. I don’t really understand the idea of focusing on scale with no business model in the hope that on an exit someone will find value. I know that’s a common idea in the tech world and you could get lucky by following it, but I think there are few people with that degree of luck – build for profit and sustainability, build as lean as possible and keep your eye on the actual ball.”
Do You Have That 1 In 100 Business That Can Scale And Land An Investor?
Only 1% of businesses are investable, mainly because that’s how many businesses can 10x their growth. There’s an art to scaling, and it starts with you.
Only one in every 100 applications typically receive funding from venture capitalists. All 100 applicants believe their businesses are scalable and worthy of funding – and yet only 1% actually close investment deals.
“Most entrepreneurs radically overestimate their prospect of success and scalability,” agrees Jason Goldberg, founder, and CEO of 10X-e and co-founder of Edge Growth.
“If you really want to scale your business, you need to know that you are absolutely obsessed with solving a problem that hasn’t been solved before – so obsessed that you wake up at night with solutions buzzing around your head; so obsessed that your mind is always on the problem you’re trying to solve. The reality is that hunger is an incredibly important success factor – hunger, the hours you’re willing to put in and your level of intensity. How far are you willing to go and how many obstacles will you overcome?”
With this in mind, Jason and Vuyo Tofile, CEO of Entbanc Group, a fintech and digital support services firm share their top 3 secrets of scale.
1. You need to shift into a ‘scale’ mindset
Start-up entrepreneurs are focused on the hustle: More work, more energy, more sales. These are all important factors in building a business, but scaling a company requires a different focus. “Scaling up is all about architecting an enterprise and strategically putting in place the building blocks that will move you from working primarily in the business to working on the business,” says Jason.
“You need to minimise the work in the business so that you can work on the business and build a great company.”
This is easier said than done though. Often the biggest stumbling block to a company’s ability to scale is the founder. “The company founder or owner’s inability to really focus on solving an initial problem for specific target market, understanding what their business really does and is offering, and finally how to truly replicate that service or offering can be major barriers to growth, and they all lie with the entrepreneur,” says Vuyo.
The lesson is clear – you can hustle and make sales without clear structures and strategies in place, but that won’t get you to scale.
“A lot of entrepreneurs love the innovative and creative mind space of start-ups as well,” adds Jason, “which is great, but scaling is all about executing all those great ideas that you innovation and creativity helped you to come up with. If you can’t do that, you’ll never be able to scale.”
“Having the ability to execute on growth is critical,” agrees Vuyo. “Execution of the vision is far more important than having a strong vision. Vision without execution is meaningless.”
2. Get the right team in place
According to Vuyo, if you want to scale your organisation, you need the right people on board – and this too is a crucial skill the founder needs to foster. “You have to be able to build an effective team around the business,” he says. “You don’t need to be able to do everything yourself – in fact, in order to scale you mustn’t – but you do need to know who you need and where you need them.”
For Jason, the lead indicator of your ability to scale is whether or not you can build a sales organisation. “Can you shift from selling to becoming the architect of an organisation that sells for you?” he asks.
Alongside this ability is shifting from hiring who you can afford to who you need. “Start-ups hire talented ‘jack of all trade’ young high potentials (who are typically overworked and underpaid). This is an essential start-up tactic. Mature firms in scale-up mode need seasoned leaders who can take each part of your business to the next level.
“Having an awesome team is your most important ingredient of success. Every senior person needs to be pretty impressive in general, spectacular in their roles, and work well as a team.”
3. Understand if your business is scalable
Not all businesses are scalable – and that’s fine. Not all entrepreneurs want to scale their businesses either. However, if you do want to scale, it’s important to know if your business falls into the scalable or un-scalable category.
“There are three basic rules of thumb,” says Jason. “First, how big is the problem you’re solving? Is this a problem that lots of people have and are willing to spend money on the solution?
“Second, what kind of problem is it? Is your solution a vitamin pill or a headache pill? How does your client feel if you don’t exist? You’re not scalable if they don’t have a painful experience without you. In other words, do they have a headache if they haven’t seen or heard from you today?
Related: Is Your Business Ready To Be Funded?
“Finally, how different is the value you bring to your client than all their other alternatives? You need to be ten times more valuable than your competitors. If you’re not, there’s too much competition, and you’re unlikely to 10x the business.”
Vuyo agrees. “Scale is all about having a service or product that is of real, tangible value to your customer. All the resources and brand equity in the world won’t help you scale if you aren’t providing real value.”
Secrets of Scale Event #3
PART 1 – BUILDING THE AEROPLANE
This segment will be the majority of our focus and will cover practical “how to steps” for scaling your business. We’ll be revealing how to design a scale ready business and walk you through common pitfalls that all entrepreneurs will encounter as they “build the aeroplane” and how to avoid them. We’ll also reverse engineer how to design a scale ready business from a 150 strong team all the way down to a 5 person team.
PART 2 – BUILT FOR WINTER
This segment is all about how to ensure that you remain profitable as you scale. We’ll unpack how to bring different revenue streams, partnerships and products/services to together to help you weather any storm.
PART 3 – SCALE BLUEPRINT
In this segment we’ll explore the systems that can help you scale, how to automate repetitive processes and outsource non-essential tasks and how to design a business that makes more money while you sleep than when you’re awake.
Listen to the podcast here:
Growing Your Revenue In A Slow Economy
The dos and don’ts for your business.
The most dangerous counter to the unpredictability of any economic crisis is… doing nothing. The same everyday attitude can ruin any company. But what’s the next most dangerous behaviour? Clumsy or uncontrolled reactions.
What is needed, therefore, is finding and embracing the less common but noteworthy opportunities that unveil themselves during slow economic times.
You can do this in two stages.
- First: steady your company by sheltering it from associated dangers and make sure that it has the cash flow needed to stay afloat during the crisis.
- Only once you’re confident that you’ve adequately prepared for the worst, should you approach the second stage: looking for ways to grow your revenue over time.
An article by Gulati, Nohria & Wohlgezogen in Harvard Business Review (2010), indicates that, “…a subset that deploys a specific combination of defensive and offensive moves has the highest probability of breaking away from the pack. These companies reduce costs selectively by focusing more on operational efficiency than their rivals do, even as they invest comprehensively in the future by spending on marketing, R&D, and new assets. Their multipronged strategy…is the best antidote to a recession.”
Stage 1: Steady your company
In the first stage of stabilising your business in a recession (especially one that could continue to slide), take the time to methodically evaluate its weak points.
- Test out a few economic scenarios both at department level and across the broader business. Assess how each might impact your organisation, and cautiously calculate the financial effects. Then find ways to reduce your exposure. Make sure that you have sufficient cash flow and access to capital, to sustain your financial stability.
- Make a strong and targeted effort to lower expenses and boost efficiency. But, while it’s imperative to be fast, it’s also essential to have a rational, cautious, and well-thought-out plan. Don’t make radical cuts that will damage your business in the long term – by, for example, risking valuable future opportunities.
- Remember that cutting expenses boosts profits, but only if the sales price and the quantity of sales stay the same. If a reduction in expenses affects the quality of your products, you may need to consider lowering your price to maintain sales. This is critical as it can cancel out any potential returns and ultimately end in a loss.
- As your customers’ needs change, re-evaluate your pricing strategies and product mix. This may mean raising prices through effective branding, like Coca-Cola and Sony have done. These organisations have such strong brands that they can get away with charging higher prices than many of their competitors… all while growing their market share and preserving quality status, even during recessions.
- You can sell off non-core businesses and peripheral (or poorly performing) operations. Don’t hold out for ‘better times’ in the hope that you’ll secure the price you would’ve gotten when the economy was stronger. If the company isn’t essential to your goals and it increases your risks in the recession, sell it now.
Step 2: Prepare for the future
- A common challenge that many businesses encounter is inflexible or obsolete business models. Reconsider yours. Innovation in technology and media is constant, yielding a perpetually evolving business landscape. The traditional publishing industry is a perfect example of this.
- Do things differently and don’t be afraid to stand out by marketing your product in a novel way. Take Jordan’s Furniture: a US furniture outlet that sells more furniture per square foot than any of its competitors thanks to a strategy called “shoppertainment”.
- Consider pursuing transformative opportunities like mergers and acquisitions. If your business is relatively strong financially and strategically, a recession can be a rare opportunity to boost your competitive position. According to a Harvard Business Review article by Rigby and Harding (2009), “…companies that acquire in bad times as well as in good outperform boom-time buyers over the long run.”
Bottom line? Businesses that can find calculated and clever ways to balance lowering expenses to endure today and carefully planning and investing to grow tomorrow are most likely to survive and thrive after a period of economic recession.
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