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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.

Increase Profitability

Are Your Scalable?

Here’s how you can assess if you’ll make it, or if you need to first make some fundamental adjustments before pursuing your growth goals.

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Pete is a classic entrepreneur. He spent 
15 years building his manufacturing firm to 
a R30 million outfit, before his big opportunity came to take on contracts worth R120 million, allowing him to scale to 
R150 million within five years. This was everything he’d worked towards. This was his retirement plan.

Five years later, instead of running a R150 million business, Pete is burnt out and broke. His company is closed and he’s lost everything. The crisis has even torn his family apart. How did this happen?

A common fate

Unfortunately, it’s a far more common story than most of us would like to admit. 70% of the top 1% of businesses (by growth potential) land up failing to scale. Sometimes, like Pete, they lose everything and close the doors. Other times, they land up bigger, but managing a chaotic hell of their own creation: A daily sprint to survive, a never-ending treadmill of frantic hustling to keep things together, with the horizon never coming closer.

The most common reasons? Either scaling something that fundamentally is not scalable, or scaling poorly; not making the right changes at the right time.

In this article, I’ll be focusing on the first reason: Attempting to scale a business that is fundamentally not scalable — because not every business can be scaled. If your ambitions are focused on high-level growth, step one is to determine if you have the 
right business model to do so. Because if 
you don’t, that’s the first change you need 
to make.

Scalability

Some companies scale easier than others. And some don’t scale at all. Let me illustrate with two extreme examples:

Very scalable: Dropbox makes an extra $10 for every user they add, while adding $1 of cost, and zero operational capacity. That is very scalable.

Not easily scalable: A start-up ad agency is soon faced with a growth ceiling created by the limits of the founder’s time and energy. This normally occurs somewhere between ten and 20 people. An ad agency is not a scalable business model because growth requires top, senior creative talent. Such individuals are rare, have attractive options, and usually prefer to either work for big multinationals, or run their own businesses. It’s therefore tough for smaller agencies to attract and retain talent without offering large chunks of equity, which can be a zero-sum game. It sometimes even works out net-negative. Unless you find a way of breaking that constraint, this is not a scalable business model.

Related: If You Want Scale, Fail Fast And Learn Quickly

So, what makes me scalable?

Building a scalable business is a bit like picking a spouse. There are a number of criteria to consider, the absence of any one of which is a deal killer, even if all other criteria are amply present. A suitor may exceed your fantasies in every regard (looks, smarts, fun, caring, etc), but if they are also prone to parallel relationships, that’s enough to pull the plug and look elsewhere.

Just as in relationships, a number of things must come together to make your business scalable. Here are the ten most fundamental drivers of scalability grouped into three core areas: Scalable market, scalable business and scalable team.

Scalable market

  1. Size (Total Addressable Market, or TAM): The market must be big enough to achieve your ambitions. As a rule of thumb for ambitious entrepreneurs, TAM must be at least 4X your business size goal. If you want 
to build a R500 million business, you need a R2 billion market.
  2. Economics: It’s expensive to scale. You need to invest in great management and top talent, plus spend on infrastructure ahead of actually seeing growth. To make that sensible, it must be very profitable serving your market.
  3. Growth: The market must be growing, and preferably faster than the rate of new competition. 

Scalable business

  1. Number one: Highly scalable businesses almost inevitably are number one, or will become number one in their market or niche. If you can’t lead the market, you must be able to lead a sizable niche.
  2. X-Factor: Every market has a bleak outlook: More competition, lower prices, lower margins. Unless you have some fundamental reason to continue to lead the market despite competitive intensity, such as proprietary tech. It must be good enough that you can be and stay number one in your market.
  3. Scalable channels to market: Some customers are just impossible to reach profitably. A scalable business has access to channels to effectively target, market to and sell to customers profitably.
  4. Scalable operating model: Scalable businesses have unconstrained access to all critical materials and talent, without breaking the economic model.
  5. Scalable economics: You can calculate the scalability of your economics with a simple formula: [Gross Profit per R10 million new revenue] / [new cost required to manage each R10 million new revenue (managers, systems, facilities, etc)]. Highly scalable businesses have a 2X or higher ratio. 1 to 1,2 is borderline and scaling will be like walking on glass. Most businesses have a ratio <1, which means they will lose money by scaling.

Scalable team

  1. Scalable founders: Statistically, most founders are not scalable. They lack the experience, skills and personality profile to make the required shifts as the business scales, and to develop the organisation through its various lifecycle stages. Scalable entrepreneurs are able to:
  • Build a great culture for >100 people
  • Attract and build an A-Team of truly impressive senior leaders, and delegate large parts of the business to them
  • Be ‘builders’ and ‘managers’ — that is, graduate from ‘entrepreneur’
  • Submit their interests to the best interests of the organisation, even when it’s painful — we see this when founders step down in favour of CEOs with corporate experience
  • Lead the transition of the business to a professionally managed company, introducing systems, processes and policies in a way that does not break the company’s culture.
  1. Leadership team: Particularly in the most painful scale up stage — going from ten to 100 staff — the key driver of scaling well is the quality of the top team. That’s why quality of early hires is a great predictor of scalability. Leaders who can adapt and be effective in a business of ten, then 20, then 50, then 100 staff are truly remarkable, and therefore exceptional. Not many manage this transition. These leaders can be effective in three completely different ‘modes of organisation’: The hustle (at ten people); The build (from ten to 100 people); The operate and grow modes. By implication, they are — or can grow into — executives. They can hustle. But they can also shift from a tactical focus (immediate fires and opportunities, action focus), to a strategic focus (future focus and system focus). They are able to run operations while transcending operations, bridging the long-term strategy, the short-term strategy, operations, culture, team, and finances, and they can do that in a company of ten people, or 100 people. Of course, you can bring in new leaders and you can replace leaders that are not scalable, but this dramatically slows the scale-up journey and can even derail it.

The result of having founders and leaders who are capable of scaling with the organisation will be the automatic development of the other key ingredients for a scalable team: Great talent, a highly engaged team, a great culture, and an effective organisation.

Related: What It Will Really Take For South Africa’s Businesses To Scale And Create Jobs

The key to growth

If you’re following the path to scale, or investing in a scale-up, it’s important to be aware of the causality amongst the above ten factors. Typically, the main factor that drives the speed at which a business can scale is how quickly founders can delegate major areas of responsibility, so that the business can continue to make rapid progress at scale.

This in turn is driven by the ‘next level’ (non-founding) leaders, as well as the leadership abilities of the founders. The problem is that early-stage companies struggle to attract top talent, unless they find people who want to be a part of the equity-incentivised leadership team pursuing an exciting opportunity. This type of career opportunity can usually attract top talent, despite the various reasons these individuals gravitate towards well-paid corporate roles and their own ventures.

But that sort of opportunity does not typically happen by accident: It’s the function of the founders getting points 1 to 9 right. In a nutshell, the first thing you need is an amazing team of founders who work smart to nail points 1 to 9, find and pursue an amazing opportunity, and then harness that to attract amazing talent in order to delegate effectively, so that you can scale beyond the limits of the founders’ time and energy.

scalability-self-assessment-tool

Click here to take your free self-assessment. 

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Leon Meyer GM At Westin Cape Town Shares 4 Experience-Driven Tips On How To Keep Your Team Productive

Productivity is a fundamental requirement for an organisation – it’s the seed that builds a business and contributes to higher profit margins.

Leon Meyer

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Productivity is a fundamental requirement for an organisation – it’s the seed that builds a business and contributes to higher profit margins. But what’s the best way to ensure employees remain productive, and happy in their day job?

The answer is simple and highly effective and I choose to sum it up with three short phrases – respect, trust and teamwork.

In partnership with my management team, which consists of about eight staffers across various disciplines, we strive to tick these boxes.

Related: 5 Surprising Elements That Boost Your Productivity (One of Them Is Colour)

In total we’re ultimately responsible for managing roughly 500 employees.

Five hundred employees across several departments is a mighty job. But with teamwork, good listening skills and the right attitude from the top to filter down, any business can run like a well-oiled machine.

I’d like share with you the essentials for building and maintaining a productive workforce, and these apply to all industries, not just the hospitality sector:

1. What’s your definition of a productive team and how do you achieve that?

We need to keep in mind that productivity is a result, one that CEOs and managing directors strive for with their teams. But what happens beforehand in order to achieve that result determines whether it will be achieved at all, and is equally important. I suggest the following to ensure a productive team:

Define roles and responsibilitiesDirection is incredibly important; everyone needs to know exactly where they’re going and how they need to get there, so KPIs are essential.

Often when roles and responsibilities are unclear, things go pear-shaped. I am an advocate for setting clear KPIs, it’s a good way to steer us in the right direction, and in turn helps to grow the business and the individual in his/her role.

Be flexible: Rigid environments are the worst kind, allow your employees some flexibility and the opportunity to be themselves in the workplace. We spend so much of our time at work, we need to be ourselves there.

Celebrate the team: When there are achievements, celebrate them, single out individuals who are excelling and living the company values. This builds morale and is indicative of appreciation, which is fundamental when running and building a business.

2. What has and continues to be your philosophy since managing a large team?

Know your strengths and weaknesses, as well as your team’s and leverage off that. Be prepared to learn from others, no one can operate in isolation, regardless of the level on which you operate. Accept criticism and don’t bulldoze someone’s ideas, that’s how you build trust.

3. What in your view are the top characteristics the team look for in a leader?

  • Be consistent – inconsistency screams bad leader
  • Provide guidance – this is key, don’t turn a blind eye, give input and council
  • Listen – always listen intently
  • Be impartial – always be fair
  • Give credit – it builds morale and shows you recognise good work
  • Be patient – Rome wasn’t built in a day, and remember not everyone thinks the same as you do

4. What’s your view on an open door policy and how does it assist with managing a team and ensuring everyone remains productive?

I believe in an open door policy. It’s essential to build and develop trust. I’m the first to admit that it takes a while to build that trust, but once the team (on all levels in all departments) know your door is always open, and that they can trust you implicitly, half the battle has been won.

I host a GM’s roundtable every two months, just to establish how everyone is feeling and where everyone is at. It gives staff the opportunity to bring their challenges to the table, and I deal with them the best I can.

It’s 100 percent confidential and line managers are not allowed to attend. During this meeting we try reach common ground, and I commit to addressing and ultimately solving the problem(s).

Related: 10 Ways To Make Your Employees 10x More Productive

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Why Purpose Drives Profits

If you want to succeed, it’s time to start engaging where it matters.

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Over the past two years, many clients have been extending brand positioning exercises into purpose-driven expressions.

When we look at it, it makes sense given the country’s demographics. With many of our fellow countrymen struggling to make ends meet, brands have stepped in to provide them with a picture of a future worth striving for.

Global customer-centricity study, Insights 2020, led by research firm Kantar Millward Brown, has attempted to understand how brands could drive customer-centric growth as well as the factors that really make a difference. The research surveyed 10 495 individuals in 60 countries, and there are some significant efforts worth investing in if brands want to engage where it matters most, in consumers’ hearts.

The research uncovered that for market-leading companies and brands, traditional value drivers such as quality, packaging, or distribution are necessary, but no longer provide a competitive advantage; most brands are capable of providing these drivers. What is important, are a few critical approaches.

1. Purpose-led brands

The study found that when companies or brands linked to a purpose, 80% of them outperformed the market. Only 32% of non-purpose led brands managed to perform better than the market. 

Related: How To Calculate Gross Profit

2. On the ground

It’s important to engage with consumers in their space and on their terms. Through the use of memorable campaigns, experiential events and activations it is critical to engage with consumers on their turf.

3. Be truthful and authentic

Consumers can smell something inauthentic a mile away, especially when it’s coming from a brand. This forces brands to strive for authenticity in everything they do, especially when it comes to marketing. Building values and principle-based attributes into your brand as a guiding tool is essential.

4. Helping consumers commit

By allowing individuals to attach themselves to a brand with a purpose, it helps consumers personally commit to a cause that they consider important. When a consumer is personally invested, the link between the brand and product or service deepens.

Related: Profit Share for Increased Performance

5. Balancing heritage and modern relevance

There is a continuous tussle in balancing the traditional market, transitional market and the new consumers brands are trying to attract. Keeping the heritage and roots of the brand true to itself, while creating relevance for the new market, is a battle marketers are still fighting.

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