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This Method Will Unlock More Capital When Selling Your Business

Here’s everything you need to understand about earn-outs.

Chris Staines

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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:

  1. Current net profit before tax (R9m) x multiple (6) x 50% = R27 million
  2. Year 2 net profit before tax (R12m) x multiple (6) x 25% = R18 million
  3. Year 3 net profit before tax (R16m) x multiple (6) x 25% = R24 million
  4. 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?

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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.

Related: How do I market the businesses for sale?

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.

Chris Staines has more than 25 years’ experience in company divestments, partial divestments, joint ventures, mergers and acquisitions. He has sold more than 60 private companies in the $1 million to $100 million range, and has worked across three continents. Chris is currently Head of Corporate Finance at Grant Thornton in Cape Town.

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Increase Profitability

What To Look Out For When Seeking A Mentor Or Coach

There is value in choosing a mentor or coach to help you build your business, says Dr John Demartini. Here he offers some sound advice on how to go about doing this so that you benefit from the experience.

Dr John Demartini

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When I was in practice I noticed many doctors attempting to build a business would seek out mentorship from management consultants, from people who have already been down that path. And there’s wisdom from learning from foresight and not learning from trial and error. But there’s a pitfall – I noticed that not everybody is able to do or sustain the actions that these consultants would suggest. Where some would follow and immediately go and succeed, there were others who would sometimes feel self defeated because they couldn’t sustain the actions that the consultants would suggest and recommend.

So a small percentage would excel and do extremely well. But there were those who would spend their money on the coaching and they’d never get anything in return.  So the question is – what made the few excel with the help of a coach, consultant or mentor? And why is it that the majority of them didn’t do as well? And it boils down to how congruent the actions of the coach or consultant are with the values of the person that’s striving to build a business.

I have listened to numerous professional consultants all offering slightly different information about how to build a business. I have taken and learned from all of them. Some of them would suggest things I just couldn’t do – it just wasn’t me – and other things that I could do. And when I couldn’t do something, the coaches and consultants believed I just was not disciplined, not driven. They would imply that I didn’t have the drive… Their material works, but I wasn’t following it.

And those of you who have had the same experience will understand what I’m saying. And you need to know that the reason you don’t do what these coaches suggest is because it’s not aligning to your values. So you are labeled lazy, undisciplined, not driven. You are given these labels instead of realising that you’re self defeating because what they suggest is not congruent with your values. And so you go to different consultants until you finally find the one who matches, whose values are aligned with yours.

So it’s important to not envy and imitate somebody with a drastically different set of values. If you’re seeking a coach or mentor, make sure the coach/mentor has a value system that is closely enough aligned to yours or you will be setting yourself up to fail. Just because somebody is successful doesn’t mean if they are your coach or mentor that they will have the values that will lead you to that same form of success. You need to either shift your values to be able to succeed in their system or you need to find the mentor that aligns more with your values. Otherwise you’ll be beating yourself up thinking there’s something wrong with you when there’s nothing wrong with you. When you find the right mentor, you will take off.

So you either have to change your values to match the objectives of the coach, or change the coach to match the truth of your own values.

So the bottom line is, if you’re going to get mentorship, coaching or consulting from somebody, don’t just select the person because they’re successful. Select them because they’re successful and they have some alignment with your mission and your values. Make sure you select your mentorship and a consultant that is truly valuable to you; don’t live in a fantasy about who you are.

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The Link Between Scaling, Relationship Building And Technology

It is the first solution of its kind in South Africa, this platform supports entrepreneurs to effectively establish legal foundations in their businesses for optimum growth and overall business success.

Nicolene Schoeman-Louw

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The challenges and opportunities of this new world and that the world is more connected than ever. The constraints of distance is no longer applicable and as a result business has little constraining borders. Networking is therefore still a component in key relationship building.

It brings me to my real point – in a world so busy and connected, what we cannot make more of is time and time, unlike any other commodity is invaluable when it comes to forging important relationships and sustaining them. So, if technology can break barriers when it comes to legal cost and time spent on it… why not? Especially when so many have experienced the consequences of not documenting the most important relationships in their business.

The SchoemanLaw SME Self- Service DeskTM is the ideal tool for any member-based organisation wanting to capacitate and empower members. It is an affordable and reliable online solution for start-ups and SMEs, where Users can customise and download their own contracts online and in minutes. It is the first solution of its kind in South Africa, this platform supports entrepreneurs to effectively establish legal foundations in their businesses for optimum growth and overall business success.

The following documents are examples of those available on the platform (currently hosting over 35 documents / agreement types):

  • Confidentiality and Non-Disclosure Agreement (“NDA”)
  • Independent Contractor Agreement
  • JV Agreement
  • MOI and Shareholder’s Agreement
  • T&C’s
  • Supplier Agreement
  • Letter Demanding Payment
  • Various HR Documents and Company Resolutions
  • BBBEE Affidavits (EME and generic QSE)

and many more!

Prices range from R195 and R895 per document if downloaded on a pay- as- you- need- basis or R249 / R495 per month on a subscription basis, this is over 75% less than usual rates if traditionally drafted by an Attorney. What is more, Users have the support of a Law Firm not only having created, but who maintains the platform and supports each User. We even offer customisable solutions. So, there support and a solution for any business regardless of size and industry are on offer.

The platform is easy to use, no prior legal training is required, and Users are supported through help texts, free podcasts, videos and training events. In the case of a legal incident occurring, you can consult with an attorney with the click of a button.

The platform is also ever evolving and completely customer- driven.  Documents are added as and when customers request them. All the documents are also frequently updated to ensure that they align to the latest best practice. There is no need to leave your legal needs unattended ever again!  The SchoemanLaw SME Self- Service DeskTM  therefore ensures that SMEs are no longer invisible and capacitates them to free up time needed to build relationships, grow and scale their businesses.

Empower your business today, go to: https://www.schoemanlaw.co.za/online-legal-services/

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To Survive And Thrive, You Need A Growth Mindset

The business case for a growth mindset is not what you think it is — if you’re serious about success, you need to start believing in yourself.

Rob Jardine

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Any leadership and personal mastery principle that booms in popularity is ripe for misinterpretation. Growth Mindset has been hailed as one of the defining leadership principles of top international companies and is believed to be one of the core skills that will keep individuals future fit in disruptive times.

Despite its popularity and importance, many companies still think a growth mindset is about the profit growth of a business. It’s not. And if you don’t know what it really is and how to apply it, you and your business might not be around to grow at all.

Growth Mindset is about Belief in Ability

Studies that we have done at the NeuroLeadership Institute (NLI) have shown that many businesses still believe that having a growth mindset means keeping eyes towards profits and striving for business growth.

Having a growth mindset is really about the continuous belief that improvement is possible and that failures are opportunities to learn. It is much larger than the objective of improving earnings, although applying a growth mindset makes one more resilient and engaged in times of change, which can only improve earnings overall.

Another study completed at NLI revealed that there are five reasons why businesses are applying a growth mindset to drive business success.

Related: 3 Strategies For Growing Your Online Business Fast

1. Digital Transformation

The most popular reason is to stay agile in the face of technological uncertainty. Digital technologies are continuing to disrupt the way that we do business and a growth mindset is put forward as a priority to ensure businesses thrive through digital disruption.

2. Business Improvement

A growth mindset encourages feedback and continuous improvement and many businesses look to embed this when they are streamlining work streams, teams and business processes.

3. Reinvention

When organisations are pivoting they use a growth mindset in their approach to reinvention of culture, operating model and leadership challenges. The growth mindset principle of seeing challenges as opportunities and not threats has an impact here.

4. Growing up

In an effort to scale a business, organisations see the benefit of applying a growth mindset to navigate the challenges and turmoil that accompanies growth.

5. Performance Management Transformation

Some businesses interview for and reward demonstration of a growth mindset. This means that they value improvement over time as a priority.

Clearly a growth mindset has business success at the core of its value-add to many organisations. It helps businesses be more agile and engaged during change, but how does it work, and how can we cultivate it?

When faced with a challenge we either tackle it head on, hoping for positive results, or we shy away from the challenge, feeling inadequate. In the brain, this is caused by how we view the challenge. If we view it as a threat, our body reacts with duress (negative stress) and we don’t prioritise our best thinking, going into survival mode instead. But if we view it as an opportunity, our body goes into euress (positive stress) and we are energised, our body is able to prioritise its best thinking. This type of behaviour can be categorised into two groups, that of a growth mindset and a fixed mindset.

Psychologists have studied these behavioural traits and found that individuals who believe in their ability to succeed are seen to have a growth mindset, whereas people who give up instantly or constantly harp on the negative aspects of a situation are seen to have a fixed mindset. Therefore, a fixed mindset sees no room for improvement and in return devalues their ability to perform.

A fixed mindset is linked to a belief that our ability is fixed and a growth mindset is linked to the belief that our ability can be grown. The surprising finding here is that our default wiring is wired to that of a fixed mindset.

Related: 10 Ways To Grow Your Business For Entrepreneurial Success

Creating a Growth Mindset

growth-mindset

Researchers have found that to incorporate the growth mindset into organisations, leaders should focus on factors such as transparency, empowerment and development.

With the digital age that we are currently living in and even trying to adapt to daily, organisations need to constantly reinvent, improve and manage performance based on digital transformation. A growth mindset assists in the rapid changes that organisations face even on a digital platform.

For a growth mindset to be established in organisations, management needs to lead the overall process. Thus, there needs to be a shared language. To ensure that there is a shared language, managers should encourage employees to build the right behaviours, and have systems and processes in place that promote a growth mindset throughout the organisation.

This can be done by:

  • Valuing and rewarding progress in others
  • Focusing and highlighting learnings from mistakes and challenges
  • Role modelling this behaviour.

Researchers have shown that a growth mindset can have measured benefit in organisations. An internal survey at a technology company showed that 92% of employees agree that learning is a lifelong exercise and 82% of managers displayed growth mindset behaviours. The growth mindset enhances the quality of an organisation for the greater good of future and current employees.

When calamity strikes in organisations, the growth mindset aids in seeing change not as a threat but rather as an opportunity to improve based on a positive mindset.

Shifting Away from a Fixed Mindset Approach

A fixed mindset hinders progress. For businesses to prosper, there needs to be an attitude of constant learning, even when failure occurs. There are certain things one can do to shift your fixed mindset to a growth mindset.

Firstly, eliminate any thoughts of inadequacy. Your thoughts determine your actions, therefore shift your thinking to that of a “can do” attitude. You need to recognise your potential, understand your abilities and that they can be improved, and know that stressful situations are opportunities to learn and grow, rather being a threat.

The minute you find yourself in a fixed mindset with a negative thought process, talk yourself into remembering your capabilities. Try replacing those negative thoughts with, “I know that I am not excelling in this area, but I am going to learn how to improve and come back stronger than before”.

A growth mindset is a phenomenon that you must constantly think about and instil in your daily life, both on a personal and professional level to see positive results, remembering that you are in a cycle of lifelong learning.

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