The global economic crisis is presenting a new set of challenges for the business owner seeking an exit as well as for the discerning buyer. Press reports indicate a larger than usual number of businesses on the market and a decrease in successful transactions as vendors cling to pre-crisis valuations and forecasts.
One of the key issues affecting transactions in this climate is that historical results are no longer viewed as a reliable indicator of near-term performance – at least not to the same extent. This significantly increases buyer risk, which serves to either reduce the market value of the business or requires some compromise on the part of the vendor.
I normally have an issue with earn-outs, particularly when they are used by the canny buyer to 100% fund the purchase of the business over a number of years from earnings. A vendor would be right to question whether they are selling their business or giving it away in these scenarios. However, as a mechanism for offsetting this increased risk and locking in a future exit, earn-outs can actually work to the advantage of both buyer and seller in this more volatile climate.
Expectations for many enterprises are nothing short of grim in 2009, so an earn-out based transaction should be structured to allow for the forecast upswing in 2010. For example, the consideration payable could be split into three tranches over a 2-year period, with 30% up front and the balance at risk based on future performance (with a heavier weighting to year 2 performance). This both incentivises the vendor to remain in the business and drive performance for longer, and leaves the business in the best possible shape for the buyer at the end of the earn-out.
With this structure for the transaction, historical results can still be used as a guide with normal multiples applied (still allowing for the “2 point gap” between multiplier and earn-out period e.g. 5 x EBIT with a 3-year earn-out, 4 x EBIT with a 2-year earn-out, 3 x EBIT with a 1-year earn-out, etc.).
Of course this doesn’t apply to all businesses. There are those that fall into the recession-proof “non-discretionary spending” category to which normal models still apply – healthcare, grocery and government suppliers, for example – whose values have remained steady or even increased as they offer a safer investment for buyers in tougher conditions.
2009 presents excellent conditions for negotiating an exit transaction, despite the doom and gloom pervading the media. The forecast rise in unemployment will have the effect of increasing self-employment and newly-redundant employees investing their payouts in SMEs as a way of buying an income stream, so we expect a new breed of buyer to enter the market to sit alongside the more traditional corporate and private-equity backed firms. According to the Australian Financial Review on 12 January 2009, “the same phenomenon emerged in the 1991 recession”.
All indications are that it is going to be a tough year, but it may not be as bad as many are suggesting. And when considering a short-term exit, transactions can be structured to still achieve the best possible outcome regardless of the environment.
Andrew Cassin is an Exit Advisor and Business Broker licensed in Queensland, New South Wales and Victoria. His company, Acquisiti is premium business brokerage and advisory firm, providing services aimed at maximising the exit result for its clients. Andrew holds a Bachelor of Business and has pursued post-graduate studies in financial services, corporate governance, mergers & acquisitions, and change management. For more information contact Andrew via email at firstname.lastname@example.org