AIM-listed Marlowe Plc has acquired wastewater treatment and compliance services provider WPL Limited for an enterprise value of £10 million. With headquarters in Waterlooville, Hampshire, WPL was founded in 1991…
When buying or selling a business, several forms of consideration (what the vendor receives for the company) may be included in the deal structure. Cash up-front is the simplest and most desirable, whilst payment of an element may be made in forms other than cash (for example, by granting the vendor shares in the acquiring company), or deferred by way of vendor loan notes or preference shares. Another form of deferred consideration is the earn-out.
Like a vendor loan or preference shares, an earn-out enables the consideration for a business acquisition to be split over a period of time by deferring a portion of it. The key difference is that an earn-out is contingent on mutually agreed conditions being met and/or that the amount receivable is linked to the future performance of the business.
Earn-Outs becoming normal
Whilst often resisted by sellers (who would rather have the cash on day 1), earn-outs form part of the structure in a significant number of M&A transactions. In our experience around a third of company disposals include an earn-out clause; recent surveys by other firms support this, with reported results ranging from 30-45% of deals including some form of earn-out.
Linking value to performance
From a buyer’s perspective, the rationale for using this deal structure is to link the value paid for the company to the benefit they receive from the performance of the business post-transaction. From a vendor’s viewpoint, this is only desirable if they can influence that performance. Earn-outs are therefore best suited to deals where the vendor will continue to drive the business post-transaction, whether as a minority shareholder or as a non-shareholding part of key management, where they will be incentivised to deliver the benefit of future growth both to themselves and to the acquirer.
Bridging the gap
If the difference in perceived value between a buyer and seller is hindering the completion of a transaction, including an earn-out can bridge the value gap by reducing the risk of overpaying for the buyer and allowing the seller to benefit from any post-deal performance increases. Common scenarios where an earn-out may form part of a deal structure include where the target business is experiencing rapid growth or is operating in a new market, as these factors create greater uncertainty over future performance and therefore appropriate valuation.
The concept can be illustrated with a simple example:
ABC Limited generated £2m EBITDA in its financial year ended 30 June 2019. Based on this, XYZ plc have offered £14m to acquire the business at a 7x valuation multiple. Whilst the vendor believes the multiple is attractive, he is valuing his business at £17.5m based on FY20 projected EBITDA of £2.5m. The acquirer is unwilling to meet this valuation at the outset as they believe the growth projection to be optimistic.
An earn-out could be used here to structure a mutually acceptable deal. The difference in valuations of £3.5m could become payable only if the target EBITDA of £2.5m is met in FY20. Alternatively, the earn-out could be set as a 7x multiple of all FY20 EBITDA in excess of £2m, generating the same result if the projected EBITDA is met whilst also incentivising the vendor to push for further growth (as they will benefit from a greater up-side) and ensuring they remain focussed if the target becomes unattainable (as they will still receive something for any growth achieved even if it doesn’t reach the £2.5m target).
In this way an earn-out can facilitate a structure which, in some instances, can mean the difference between a transaction completion or not. However, there are several considerations which must be borne in mind when deciding whether such a structure is appropriate. We will look at these in our next article.
At PKF Francis Clark we provide support to purchasers and vendors at all stages of a business sale or acquisition. For further information please contact us here: https://pkf-fccf.co.uk/contact/
By Chris Potts