How Earn-Outs Impact the Sale of a Business
Earn-Outs and how they impact the sale of a business
By Matt Slappey CBI, BCI
Certified Business Intermediary; Mergers and Acquisitions (M&A) Advisor
Former GABB President Matt Slappey gave a presentation on earn-outs, what they are and how they can be used in the sale of a business. For those who missed this valuable presentation, the GABB gives you access to a recording of the speech and an outline of his PowerPoint presentation.
Earn-Out PowerPoint Presentation for the GABB
Earn-out:
Definition according to Google:
A provision written into some financial transactions whereby the seller of a business will receive additional payments based on the future performance of the business sold
Wikipedia defines it as:
Earn out refers to a pricing structure in mergers and acquisitions where the sellers must “earn” part of the purchase price based on the performance of the business following the acquisition. In an earn out, part of the purchase price is paid after closing based on the target company achieving certain financial goals
Reality of an Earn-out
- An earn-out is used in most cases to bridge what a seller thinks his/her company is worth to the price that a buyer is putting on that same business.
- When a business is full of “potential” that the owner has never actually realized (some of this is real and some is smoke)
- Keeps negotiations alive when the parties seem far apart.
Scenario
- You have a listing/engagement with a client.
- The client has $500K per year in cash flow.
- The market will tell you that a buyer’s offer of 3 x cash flow is not unreasonable.
- The seller wants $2,000,000+ or a 4x+ multiple
Things to understand
- Why does the seller think the company is worth more than the market rate?
- Is there a valid reason that the company is worth more?
- Is there true “unrealized potential”?
- Is the company about to land a large contract or opportunity?
Examples of Companies that lean towards an “earn out.”
- Consulting companies
- No sales reps other than the owner
- No management other than the owner
- Family members involved in the business
- Professional practices
SBA Deal?
- If you are going to seek financing via an SBA loan for your deal, do not pursue an earn-out because the SBA does not allow the use of earn-outs. They require a defined purchase price.
- This is not the SBA lenders in the room making the rule, it is the SBA.
Earn-out Structure
- Create an earn-out that is the most simple and effective way to measure company or owner performance.
- Complicated earn-outs must be clearly understood by all parties and all parties must be able to verify all the information required to create the payouts
Types of Structures
- Revenue Goal
- Gross Profit Goal
- EBITDA or SDE Goal
- Retention of current clients
- Acquisition of new clients
Tax Implications
- Most earn-outs are treated as an “Installment Payment” which allows taxation in the year it is actually received.
- Can use this technique to keep taxation of sales of smaller businesses under the top tax rates.
- It should also be noted that there may be situations in which a seller would choose to recognize the sale of a business currently and forego deferral treatment, such as when a business is sold at a loss, or when it is known or expected that tax rates will increase in the future.
Taking care of employees
It is possible for an owner to expense a portion of his earn out payments that are then paid to employees for retention or performance that leads to the seller receiving an earn-out payment. Scenarios change as to how to legally do this based on differences in an asset or stock deal, so consult a qualified attorney and/or tax advisor.
This can really motivate employees to achieve the earn out goals, thus earning it for the seller!
Summary:
Earn outs are a powerful tool to bridge the gap in business values.
Both sides can benefit from using them effectively.
There are tax implications and advantages of earn outs.
Knowing how to navigate earn-outs can help you close more transactions.
Questions?
Matt Slappey, 404-486-0350, mslappey@murphybusiness.com
www.murphybusiness.com/decatur
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GABB Today April 2014 upcoming events
GABB Today UPCOMING EVENTS:
Get out your calendar because the GABB has an impressive lineup of speakers and events in the coming months
Buckhead Coalition Founder Sam Massell to speak to GABB on April 29
:Sam Massell, the founder of the Buckhead Coalition and former mayor of Atlanta, will speak to the Georgia Association of Business Brokers on Tuesday, April 29. GABB Affiliate Susan Kite, SBA Business Development Officer and Vice President of Signature Bank of Georgia, is sponsoring the meeting.
Massell, a life-long resident of Atlanta, has had successful careers in real estate brokerage, elected office, the field of tourism, and association management. He spent 20 years as a Realtor, 22 years in elected offices, including eight as President of Atlanta’s Board of Aldermen (now known as the City Council) and four as Atlanta’s mayor. In addition, he has served a four-year term on the Board of the Metropolitan Atlanta Rapid Transit Authority, and was a Board Member of the Atlanta Committee for the Olympic Games.
The GABB’s monthly meeting at 10:30 a.m. at the South Terraces Conference Center is preceded at 9:45 a.m. by a free light breakfast and networking session. The GABB is the state’s largest professional organization dedicated to buying and selling businesses and franchises. The South Terraces Conference Center is at 115 Perimeter Center Place, Atlanta. For more information about the GABB, contact GABB President C. David Chambless at dchambless@abraxas.biz or 404-627-4454.
Broadcaster Bill Crane to Speak on May 27
Crane to speak May 27 : Save May 27 to hear broadcaster and PR specialist Bill Crane. That’s the day after Memorial Day, but you will want to hear what Crane has to say about the 2014 election cycle, including the May 20 results from races for Congress, Senate and governer, as well as the July 22 run-off. Crane has nearly 25 years as a senior communications strategist. He began his career in broadcasting, and later served in senior communications staff positions under Georgia’s Gold Dome as well as on Capitol Hill, working for two U.S. Senators and one Governor, in both major political parties. Crane also has significant economic development experience, serving as Vice-President of Marketing and Communications for the Metro Atlanta Chamber of Commerce during Atlanta’s Olympic years.
Brian Harper Senior Vice President of SBA Lending with Atlantic Capital Bank will sponsor the May 27 meeting. For information about sponsoring future GABB meetings, contact GABB Board Member Mike Kelly.
IBBA Courses for GABB Fall Conference on Sept. 30
The GABB Fall Conference will be held on Sept. 30 with two popular speakers and IBBA credit. Course #117 – Understanding Tax Returns (4 credit hours) Course #424 – Pro Forma and Cash Flow Statement: Tool For Closing More Deals (4 credit hours) Both courses have been approved for IBBA credit for the CBI and will be eligible for Real Estate Continuing Education Credit. We will notify all GABB members when registration information has been finalized.
Understanding Tax Returns: Do you often get frustrated when reviewing a tax return because you just do not know where to find the information you need? Understanding how information is transferred from financial statements and presented in tax returns is critical to effectively achieving an accurate recast. This new IBBA Boot Camp Series Course will assist participants in understanding how to decipher and properly locate information in tax returns that is needed for recasting. Learn how to identify the tax returns for the four entities commonly encountered by an intermediary, identify the primary schedules in tax returns, explain where to begin recasting using a tax return, locate key recast items within tax returns and compare the reporting differences of financial statements and tax returns.
Pro Forma and Cash Flow Statement: Tool For Closing More Deals: EBITDA has often been used as a proxy for cash flow, but in today’s challenging business climate buyers no longer put much faith in “proxies” or approximations of earnings. Due diligence is much more rigorous and terms are much more open to creative negotiations. Having a well thought out economic vision for the business, i.e. Pro Forma, along with a clear understanding of believable future cash flows, is critical in attracting and negotiating good offers for your client. This course will make use case studies to provide insights and examples in working with your clients to create solid pro formas and cash flow statements, and how to use this valuable information to better market and negotiate your deal.
Check your GABB profile:
GABB members, both affiliates and brokers, please go online and review your GABB profile. If your profile does not have your photo, and you’d like to have that posted, please send a color jpg head shot to Diane. If your profile does not appear in the GABB directory, it could mean that you have not renewed your membership for 2014. If there is something missing or inaccurate, please contact Diane to update your information.
GABB members represent owners of Georgia businesses and help them estimate the value of their businesses, create marketing plans and strategies for the sale of their businesses, and identify and qualify potential business buyers while keeping the sale confidential from employees and customers. Many of today’s business buyers are individuals who have decided not to re-enter corporate America , but are ready to control their own destiny by purchasing and operating a Georgia business. Many business buyers are also current business owners who saw 2013 as an opportunity to grow their revenues through purchases of competitors or strategic partners.
Read MoreUsing Pratt’s Stats To Sell More Businesses
One obstacle to selling a business is an unrealistic asking price. GABB members can obtain access to Pratt’s Stats which can help sell more businesses by helping to price a business accurately. While Pratt’s no longer offers GABB members complimentary access, if a broker submits the details of a sale, they can obtain access to the database for a period of time at no cost.
The following is from GABB President Matt Slappey’s presentation at the July 2013 GABB meeting.
Pratt’s Stats can help you:
- Set REALISTIC owner expectations.
- Feel confident that you can support your asking price for your listings.
- Become knowledgeable about many industry values.
Brokers should use this tool in conjunction with Business Reference Guide and other sources. Pratt’s Stats allows you to validate information from each source!
What is the difference between BIZCOMPS® and Pratt’s Stats®?
BIZCOMPS® mainly covers main street businesses. As of February 2013, the median selling price of all the transactions in BIZCOMPS® was $168,000. BIZCOMPS® data includes up to 21 data fields per transaction.
Pratt’s Stats® covers both main street businesses, middle market transactions, and larger M&A transactions. As of February 2013, 60% of the deals in the Pratt’s Stats® database are businesses that sold for $1,000,000 or less, and 38% of the deals are businesses that sold for between $1,000,001 and $500,000,000. As of February 2013, the median selling price in Pratt’s Stats® was $440,000. Pratt’s Stats® data includes up to 89 data fields per transaction.
Does BIZCOMPS® overlap Pratt’s Stats®?
There is little overlap of information from BIZCOMPS® and Pratt’s Stats®, although there may be a few transactions that are in each database.
Do BIZCOMPS® and Pratt’s Stats® calculate transaction multiples the same?
No. There is one key difference between the two databases. BIZCOMPS® sales are all asset sales and the selling price does not include the cash, accounts receivable, accounts payable and inventory. Pratt’s Stats® sales can be either an asset sale or stock sale. For an asset sale, the Pratt’s Stats® selling price generally includes inventory and generally excludes cash, accounts receivable and accounts payable.
What is Pratt’s Stats?
- A Database of 19,500+ Private Company Sales
- Two Decades of Accumulated Transactions
- Additional Articles and Quarterly Reports
- Run by Business Valuation Resources, LLC and located at www.BVMarketData.com
- It’s FREE for GABB Members
- Board Members may issue a password
See a detailed primer describing how to use Pratt’s Stats Transaction Data for Private Company Valuations.
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Business Valuation: Do the Financials Tell the Whole Story?
Many experts say no! These experts believe that only half of the business valuation should be based on the financials (the number-crunching), with the other half of the business valuation based on non-financial information (the subjective factors).
What subjective factors are they referring to? SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats – the primary factors that make up the subjective, or non-financial, analysis. Below you will find a more detailed look at the areas that help us evaluate a company’s SWOT.
Industry Status – A company’s value increases when its associated industry is expanding, and its value decreases in any of the following situations: its industry is constantly fighting technical obsolescence; its industry involves a commodity subject to ongoing price wars; its industry is severely impacted by foreign competition; or its industry is negatively impacted by governmental policies, controls, or pricing.
Geographic Location – A company is worth more if it is located in states or countries that have a favorable infrastructure, advantageous tax rates, or higher reimbursement rates. A company with access to an ample educated and competitive work force will also enjoy increased value.
Management – A company with low turnover in management and a solid second-tier management team comprised of different age levels is also worth more.
Facilities – A company operating profitably at 70 percent capacity is worth more than a company currently near capacity. Equipment should be up to date and any leases – either equipment or real estate – renewable at reasonable rates.
Products or Services – A company is worth more if its products or services are proprietary, are diversified with some pricing power, and have, preferably, a recognizable brand name. In addition, new products or services should be introduced on a regular basis.
Customers – A company is worth more if there is not heavy customer concentration, but rather recurring revenue from long-time, loyal customers, as well as from new customers created through a regular and systematic sales process.
Competition – A company not contending head to head with powerful competitors such as Microsoft or Wal-Mart will rate a higher value.
Suppliers – Finally, a company is worth more if it is not dependent on single sourced key items or items available from only a limited number of suppliers.
Copyright 2012 Business Brokerage Press, Inc.
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