Valuation Principles and Working with Earnouts

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Good, Kassan. Happy to be here.

Hey, thanks for taking the time. Can we kick things off with a little bit about your background?

As you mentioned, I'm co CEO of VRC. Been in the role for about 10 years. I've been at VRC for about 21 years, was an analyst working with clients, doing all of that sort of stuff, valuing companies for 10, 11 years at VRC, and then was at another firm for five years prior to that.

So you've got a pretty long career of all focused on valuations.

Yeah, 25 years. I've been doing this more than 25 years at this point.

One, I got to give you a special thanks for letting me use your office space every time I come to Manhattan. It's just wonderful to have this opportunity to get a nice corner suite here in Midtown. But the other thing I've noticed, hardly anybody comes to your office. Like, I get pretty lonely here sometimes. You know, you operate with a pretty remote environment. I take your company's adopted to it. And then one of the things you mentioned to me prior was that you added 100 people to your company in the last two years. Tell me a little bit about that. I'm looking down Midtown and everybody's bringing people back to their office and they're filling them back up. You haven't done that.

In some ways, it was strategic. Hasan at the beginning of the pandemic or midway through the pandemic, maybe deal activity really started to heat up and we needed a lot of people and our people didn't want to come back to the office. Typically, what would happen if people would come into the office and shut their door and you wouldn't see them? What we found is that people were happy with the flexible work environments. All of our offices are open. They have been open for two years. They come in. People can come come in when they want to, if they want to. But quite frankly, what we find is the vast majority of the people don't want to come in. And that's okay. Technology today with zoom and teams allows us to stay in touch, have face to face contact. It may not be in person contact though. And so with that, we're able to do our job, do it effectively, but also have the flexibility to do the personal things that we want to be able to do. And it could be working out in the middle of the day or picking up a child from school or cooking dinner, we find for our people this works. You know, at the same time, given the environment we're in, last year we worked on 1200 deals. We valued 15,000 security. So we're very busy and our people take their job seriously. They're professionals. There is no 9 to 5 in our environment. If there is no 9 to 5, you want to give people the opportunity to be able to do the things they want to be able to do. Personal things again, work out, take care of a family member, take care of, chore, whatever it may be. The work from home environment really allows that. At the same time, though, I will say our offices are open, so there's a handful of people who do come in every day or a couple of times a week. Our offices are open for that. But quite frankly, we've outgrown all of our office space. And so if we were to bring everybody back in today, we'd probably need double the space. And so this is a really efficient and effective way to give people what they want. And in our business, our turnaround times are quick and so there's no hiding if somebody's not doing their job. You notice pretty quickly flexibility is a.

Big part of your culture.

Yeah.

And you save some money. All the extra office space.

We put it back though. We put it back into our people. We've signed up for virtual training programs, especially for the younger people who are coming into our industry. We do more get togethers where we bring everybody in. In some cases, people are flying in, driving in to catch up with the rest of the, the rest of the group. And then we have team events as well. And you always hear about those team building events, quite frankly, that we probably weren't great about doing five, 10, 15 years ago. But today, whether it's we're going to go to topgolf or maybe play a round of golf or play some tennis, things like that, which help you build rapport with your team. We're doing and we're spending money on that. So it's not all just dropping to the bottom line. I would say it's putting money back into our people, giving them the tools, giving them the resources to be successful here and at the same time maintaining our culture. I think that's a important part of it.

Less money to the landlords, more money to spend at the bars.

Maybe a little bit. You're right.

When people hit you up for deals, what's the expertise they're looking for?

We Provide an independent opinion of value. Okay, now why would you need that? Maybe an obvious reason is if you're doing a deal and you need a fairness opinion. So the board might be looking for somebody independently to provide a view on whether the deal is fair or not. We do some of that. A lot of our work, though, is done for statutory regulatory purposes. For accounting purposes, you may need to account for the purchase price. It's called a purchase price allocation. So we're valuing intangible assets, real property, machinery, equipment, inventory, complex securities that may be part of the structure of the deal. So we're valuing all of those things for accounting purposes. We may be valuing assets or entities for tax purposes. And then also a bigger part of our business. As I mentioned earlier, we valued 15,000 securities in 2022 is what we call portfolio valuation. So we're working with all kinds of asset managers, private equity, hedge funds, BDCs, mutual funds, in valuing their illiquid securities for them so they have a better understanding of what the value of those securities are. A lot of that work is quarterly, some is monthly, some is annual. We even have a few that are daily. We're experts on valuation. That's what we do. And when somebody wants an independent view on what's value, what the value is, that's when they come to us. Cool.

All things valuation.

Yeah.

Tell me what's going on in the market today.

I was talking to somebody in my network recently and they were saying they've never seen such diverse opinions on where the economy is going, where's inflation going, where are interest rates going? And as a result of that, I think you see the impact in the stock market in the valuations of companies, both public and private. There's a lot of uncertainty in the market. I would say it does feel as though in the next six months or less, we should have more clarity on the market and where we're going. But there's always something in valuation. Again, I've been doing this for over 25 years. There's always something. There's always some reason for concern. There's always some reason to wonder, okay, are we at the top of the market or the bottom of the market? How long are we going to continue to go sideways? It just. There's always things to talk about, which makes it very interesting. It's been a phenomenal ride for 25 years, but there's always something.

I'd say we've seen a pretty big correction with tech companies, but then when you look overall at deals happening now some deals are being done in a high valuation, others aren't. What are your thoughts on that?

There's two things there. Number one on the tech side, we saw through the pandemic that hey, maybe the world has changed. And tech, where you don't necessarily have the same kind of in person interactions is the way to go. And maybe a lot of those companies hiring to support growth in their valuation, growth in demand, and now maybe a little bit of a reset. Valuations are still higher than maybe where they were three years ago, but not as high as they were maybe through the pandemic. In terms of other valuations, there's definitely a movement to quality. If you've got a good company with good fundamentals, good management, you're going to get a premium, you're going to continue to get a premium. On the other hand, if you're not that a player in your market, you might not get that kind of premium, you're definitely not going to get that kind of premium. But for a while all companies seem to have a premium associated with them and I think that's gone away. It really depends on where you are in the market. And there is an emphasis on quality right now.

Yeah, that's a really good point. You think that's just overall within your sector, how you're positioned, or the sector itself?

What I have seen over time is that investors do seem to move as a group, as a herd, into different areas. I mean tech through the pandemic, but over my career I've seen other industries where investors just seem to move as a group into and then out of. And that can cause dramatic shifts in supply and demand and as a result significant shifts in price.

I need some advice. Yeah. Tell me as a founder operator, how do I best position my company for the best valuation?

It's about cash flow and earnings. Yeah, you call it. EBITDA is a good indicator of cash flow. At different times it can be different things. In the past few years it may have been more about growth, revenue growth as an example, or users or something like that. But cash is king. Being positive from an EBITDA perspective is always good. Having growth from an EBITDA perspective is really good. Although at times we've seen, whether it's the dot com time period in the late 90s or more recently through the pandemic, I think sometimes there can be an emphasis on something other than cash flow or something in addition to cash flow, which may result in a lot of enthusiasm. Let's just say in terms of people getting into One space or another.

You know, as an operator you have some level of control in how you run a business because you can invest in growth or you can optimize for cash flow. I can go from one extreme to the other. Where do you think is that prime spot? Because I can really run lean to mean and focus on bottom line cash flow or I can really focus on top line growth.

There is never any right answer in your role. In my role, we've got to figure out where do we put our resources and that's a big part of, I would imagine your role and I know it's a big part of my role is there is scarcity in resources and how do you apply them? Certain environments, it's, there's a huge opportunity in front of us. Let's put the money into growth. And at other times it's kind of like, okay, let's watch our pennies, let's be a little bit more pragmatic on where we're spending and focus on profitability. I hate to say this, but it depends.

But generally speaking, you've seen the pendulum shift from pure top line growth to profitability.

Cash is king. To the extent that you've got positive ebitda, that's a good thing. If you got growth in ebitda, that's a good thing. If there's a potential for more growth in ebitda, in some ways that's the flight to quality we hear in the.

News about these big rounds of funding. I guess some founders maybe get a little envious of that, but when you look at it, I feel like there's this big element of storytelling that some founders are extremely good at and that's partly what drives them to tell the story and achieve those big rounds of funding at high valuations, what are your thoughts on that? How much of the element of storytelling actually comes in play with valuations?

You do need to be able to tell the story. The story needs to be consistent. It does need to be effective and efficient in able to get people excited about, hey, this is the place you want to be. Having said that, I think there is also an element of being in the right place at the right time. And we can think about the recent crypto related bankruptcy. Some of those folks were just in the right spot at the right time. There was a lot of enthusiasm to be and a lot of fear of missing out. I would say from an investor perspective and creating demand maybe through storytelling is important, but if you're in an area that's maybe not quite as sexy even if you're a great storyteller, there may not be a lot of interests. It's a combination of things, like a lot of things in life, I would say. But I do think being able to tell a good story is important.

How much of the valuation gets anchored by the investors and what they've invested in at their perception of valuation versus you coming in as a third party and ideally be more objective about what the value is. Because you can look at some of those companies, right? They got the especially what we saw in the good times. How does that come in, do you say? Well, we've already know that Tiger and these other big VCs have invested in. We're going to account for that. And then because we don't want a big discrepancy versus no, this is what it's actually worth.

Especially with early stage companies, those valuations are hard. The range of potential values is significant. If you can point a real market transaction where people have put money in and invested in the company, that's a really good fact pattern. So of course you're going to rely on that and that's important. Now, we do also do a lot of work, probably the vast majority of our work in more mature industries where the valuations are a little bit easier and the bookends aren't quite as far apart. You're always looking for market evidence of what the value of the company is. You may look to the market to see recent transactions. You may look to public comps where they're available to see where they're trading at and use some sort of metric, usually ebitda. But if they're pre ebitda, maybe it's revenue or something else. And then you do a cash flow model and you look at what do we expect from this company going forward. And as I said, certain companies are easier to project than others. Right. So if you've got an earlier stage company, it's just really hard to project. And there's a lot of risk in getting from a hundred people to five hundred people to a thousand people to are you going to be able to do that? And does management have the ability to scale the company like that? It's difficult, yeah.

There's a lot of interesting variables when it comes to valuation. It sounds like you got this ability to storytell and build some demand around it. And then how you forecast your numbers partly falls in play of how you get valued.

The two have to be consistent with each other. I would say as we go in to talk with companies, we want to hear the story. We're going to judge the people that we're talking to based on the story that we hear and the numbers we see. And look, the vast majority of times the story's aligned the stories with the numbers and the people. It's like, okay, great, this is the A team. They know what they're doing. We feel comfortable. But I will say over my career, every once in a while, you walk out of a meeting and go, wow, this is not going to work. There's no way the numbers are wrong or the people. It's the wrong people, or maybe both. Anytime you're talking about valuation, number one, you're talking about people. Can you trust them and do you believe what they're saying? I think that's an important part of what we do, is we're talking to management, talking to the investing group, and looking at the numbers they're projecting.

How about advice on what not to do as an operator?

It depends on what stage the company is at. But one of the things that we do see from time to time with maybe earlier stage companies is that they're not focused enough. They see this opportunity, that opportunity, they want to grab them all. And so just being laser focused on who you are and what you want to focus on is really important. Once you show that you can execute that plan, be able to deliver the results that you said you could, then I think there's an opportunity to maybe diversify and move on to other areas, but be focused. Who are you? What are you? Where do you want to be? How do you define success? I think all of that is really important.

I can see that as a thing that could be a challenge for some founders. Obviously, don't get too diversified. Where you're not focused is one element. Anything else. I know keeping clean books is probably important.

Keeping clean books is really important because the more other stuff you have going through your books, the harder it is to see if you're actually meeting your goals and whether you're actually achieving what you said going to achieve. I think that's really important. Beyond that, do you have a plan? This is what we want to do, but is it reasonable? You have the skill set to do it? Do you have the people and resources around you to help you to execute that plan? Plan and to get to the finish line? A lot of times in your role, My role, I mean, it's not even about you and me. It's about all of the other people on our team. And there's lots of areas where you've just got to Rely on the team around you and have that solid team around you, one that you can trust. I think trust is a real important element for me, D.J.

You got to give me more. I need the hacks, the tips and tricks around valuation. What are some of these things that you really would be good for somebody maybe first time doing M and A, Maybe there's these impairment things or these other things, but what are some of these things that you can try to get ahead of that you've seen as common? First mistakes, first time doing a deal.

Too much optimism is probably the number one mistake that I've seen. When you look at what are the drivers of value, it's revenue and growth of revenue. It's margins, it's cash flow, it's also risk. And the risk comes up in the form of the discount rate. Sometimes there's this view of, hey, we're going to take over the world, we're on a rocket ship. But the reality is that there's so many hurdles to overcome to get that. And some of the biggest ones are just the people issues that you have to deal with to be able to get to where you want to go. And you're going to have setbacks, you're going to have issues. And maybe the individuals that help you as a startup aren't the ones that help you as you get to the next level. We know where we want to go. Do we have the pieces of the puzzle to be able to get there? Whether it's a startup or let's say you're working on your first deal, there tends to be a lot of optimism around the forecast that's put together, the growth, the margins, the synergies, maybe underestimating risk, which also increases value. Those are some of the things I see. And look, it's not unusual for us when we're working with deal teams that they present a very optimistic view of what a transaction is going to do. And oftentimes we're working with the accounting group subsequent to that to test for impairment. And the forecast there looks very different and the risk profile looks very different. There's often a resetting of lens, I would say, as you move from the deal team to the corporate team.

Let's say we did that first deal, inevitable, rosy glasses on, it looks great. We paid through the nose for this company. And then afterwards, what are the issues that come up? Is this impairment thing? I don't understand it. You're going to have to teach me this stuff because what's the big deal about that? Why do you have to go through that.

It's a big deal for a public company. And instead of 20 million, maybe we're talking 200 million or 2 billion in size if a public company is doing a deal. The way these things typically go, in my opinion, is it's almost like buying a house. You start looking at the house and then you fall in love with the house and say, we really want this house. And so as you're putting together the model, the model changes from a reasonable outlook for what growth and margins and things of that would look like as well as the risk profile, to something where it's no, we've got synergies, we've got opportunities that will lead to higher growth, higher margins and less risk. And all of that points to more value. The price that you pay increases again because in some ways you've fallen in love with it. Now you got to support it a year afterwards. You've got to now test it for impairment. You hear lots of things in the press about deals being bad for companies and all that. I can't say that I've worked on a lot of deals, probably into the thousands of deals over my career. Definitely hundreds, if not thousands. Deals are good. They help diversify a company's revenues, diversify their product lines, diversify their customer base. Lower risk, they're all really good. But when you're in this impairment situation a year after the deal is done, and the deal model is really optimistic again because you've fallen in love with the company and you really want to get the deal done, there is pressure to make sure that there's no impairment. And the accounting rules require you to test for this. Okay. So you got to redo the calculation and see, okay, what does the value look like today versus what it was at time of acquisition?

What's the difference between an impairment and a write down?

No, it's the same thing.

Same thing, just different words.

Yeah, yeah. So impairment of goodwill is a write down of goodwill. Yeah.

If I want to impress more of the valuation people, I'll tell them it's impairment. Use that word versus.

Well, that's the accounting. That's the accounting term.

Then my deal, folks. We'll talk about write downs, okay? But when we go through that impairment, how do you go about it? If you buy a company and then you fully integrate this company, like, how are you even supposed to measure that?

Goodwill is tested at what's called reporting unit level. A reporting unit's either a segment or it's a level just below a segment. If you integrate it, okay, you don't test it necessarily at the acquisition level. You test the reporting unit or if it's just the segment, then you test at the segment level. There's lots of confusion on that, to be honest with you. The rules have been around for, yeah, 21 years, maybe 22 years. Yet there is still confusion on, okay, how do we test for impairments? It's at this level called a reporting unit, which is probably in many cases it's more than just the acquisition. It may be as much as the entire segment or it might be what's called a reporting in it.

If you ended up doing a write down, what's the implications of all that?

Usually when there's a write down, it's a write down of goodwill. We overpaid. Goodwill is the excess purchase price at the time of the transaction. We're going to adjust the goodwill on our books. It's a non cash item. So from a cash flow perspective, it's not overly meaningful. But from a reputation perspective, I would say it's meaningful. The management is saying, hey, we overpaid on this acquisition. I don't know of many CEOs or CFOs that want to make that admission. So it's something where there's a lot of work that's done around it, a lot of scrubbing of the forecast, lots of discussion to make sure that if there is an impairment, there truly is an impairment, that we did overpay and that the value of the company today or the reporting unit today or the acquisition is less than what we paid.

For doesn't impact write offs or taxes as much.

No, I mean it's a write off of goodwill. That's typically what happens. And the whole tax side, that's a whole nother element. The deal might be taxable, it might be non taxable. There's a whole bunch of other issues that are relating to that. That's an hour long discussion on itself. Okay.

But I get it. Impairments are a thing and that's like the thing you want to avoid is having the impairments. Any other things like that I should know?

Valuation wise for public companies, there's lots of different things to think about. At the time of an acquisition, you've got to do something called a purchase price allocation where you allocate the purchase price to various assets and liabilities that you have acquired. International deal or a multinational deal. You may have to also, for tax purposes, allocate value to the various entities around the world that you've acquired subsequent to the acquisition. You may have to test for impairment and that's an important element of it. There's other things that you need to do around the valuation space, maybe more. For private companies, you might have to value stock options, restricted stock, profit interest or an earnout that was part of the deal structure. There's various other things that you might need to do from a valuation perspective as part of a transaction or subsequent to a transaction.

When it comes to allocations, what's ideal in terms of putting things in IP versus property?

You try to do what's right. We're specialists in coming up with those values. We've got people who are experts in valuing machinery, equipment, we've got experts in valuing real estate, experts in valuing intangible assets, intellectual property, that sort of stuff. You try to do what's right because that's the best answer for everybody.

So what's like the shady things that you've seen people do?

This idea that, oh, maybe it would be beneficial to have more value in goodwill because then there's less in amortizable or depreciable assets, lower expenses, on the other hand, there might be, hey, we're better off having more value in fixed assets. Honestly, Kasan, what I have found over my career is that the best thing that I can do for my clients is to give the best estimate of what I think the value of those assets are. If you start playing this game of oh, it's beneficial to have more value here or there, then you're going to have another purpose where it's beneficial the other way. You just start creating problems. In my opinion, in the world that we're in today, there's so much scrutiny from so many different angles. Not only management auditors, sec, pcaob, it doesn't pay. You're better off doing the right thing and doing what's best for yourself and your clients long term and really providing numbers that stand up to the test of time. Vrc, that's what we've built our reputation around. It's this long term view that we're going to do what's right and come up with values that stand up to the test of time. And that's proven not to be true.

I'm glad you're not my tax guy. I'm just kidding. I'm just kidding. M and a science. We fully believe in doing the right thing. So 100% support you, especially since you're a sponsor of ours. So I 100%. I agree it's the right thing to do, is do the Right thing. I want to talk about earnouts. Give me the 101. Let's just give me a breakdown what earnouts are and how they're typically, typically structured.

We're seeing a lot of deals with earnouts and have been, I would say, for a long time. I would imagine in the future here being this year, the beginning of this year, we're going to see even bigger earnouts. The reason for that is, is that there's just. They're used to bridge a gap between buyer and seller. Sellers have this expectation of, hey, the value of my company is way up here. And the buyer goes, I'm not sure about that, but if you do these three things, okay, fine, we'll pay you. It's used to really bridge that gap. The structures that we see. A lot of times people like to keep it simple, I think, which is good. There's some sort of revenue threshold or EBITDA threshold that needs to be hit to be able to earn the earn out. Sometimes in the healthcare pharmaceutical environment, you might see things that are a little bit more structured. If you hit phase one, you get X. If you hit phase two, you get Y. If you get to phase three, you get something else. And there can be a more nuanced approach, more structured approach with those kinds of companies, but they're very popular. We see them a lot. Probably 70% of the deals that we work on, there's some type of earn out. It wouldn't surprise me if they're even more popular as we move Forward here in 2023.

What are like typical terms you see on earn out?

You got to hit this threshold and it's typically closer in a big part of an earn out is do you trust the party on the other side to pay the earn out? And so the further out you go, I think the buyer would probably love to say we're going to push the earn out five years. But does the seller really have control for revenues or ebitda? Five years out is probably the question they have. And so what we tend to see are earnouts that are one or two years out. And the threshold that you need to meet seems to be more reasonable and you feel like it's based on your effort and your actions as opposed to maybe the acquiring part party. Of course, the other part of it is just if somebody says they're going to pay you a million dollars, do you think they have the ability to pay you a million dollars? Right. So from a seller's perspective, that's always something you need to think about. Is do you trust the party on the other side of the table to do what they say they're going to do? Now, I would say that we rarely see situations where the buyer doesn't live up to what they said they were going to do. But it could be, to be honest with you, more than anything what I see is buyers bending over backwards. They don't want to have the reputation of hey, the seller earned this and we didn't pay them, we didn't do what we said we were going to do. It's more kind of like, yeah, yeah, they were close. We'll just, you know, make them whole. It's the right thing to do.

Okay. I think of the elements that go into earn out, there's money I'm paying you today upfront and there's delayed money I'm going to pay you. We're going to break that down because it sounds like there's a few ways to construct that and then you have a timeframe, end to end timeframe, you said one or two years, but would that vary industry to industry? Because if it's a consulting company, for example, and this is so much about the people and the chief bails and yeah, that'd probably be longer or no.

I think in some of those situations what you have is rollover equity instead of an earn out. Let's just backtrack for a minute. There are different components to what the consideration looks like. You have cash upfront, you have earnouts, and then you also have rollover equity where the selling shareholders now have equity in the new company. If you've got a situation where the individuals at the company are critical, what better way to make sure their interests are aligned, they still got skin in the game and all of that sort of stuff than by giving them equity in the new co. We see especially on the private equity side, a lot of the deals have rollover equity. That's a very common structure.

How much of it and what do you mean, say rollover? Is it this amount is going to turn into equity? No, it's just, we're just going to give you equity.

Well, no, I mean you, you own the equity of the company. If you're the selling shareholder or the selling shareholder group, let's say you've got a group of five people that own 100% of a company. Maybe in the new structure you own 20% of the company going forward and the rest is owned by private equity.

They do that, they majority buy, they keep you minority stake and that's not necessarily part of A retention plan that's part of the deal structure.

I'd say it's both. What better way to retain people than.

For them strategy of retention plan. But it's not earned in, in terms of. I mean that's separate. That could be separate. And saying, hey, here's my compensation agreement and I got some options accrued. Meanwhile still retain this percentage. Selling the company out. Basically I'm selling 80%. Keeping some percent.

Yeah, okay, exactly.

I get that. And then what would be the reasons to vary the length of the earn out itself?

From a buyer's perspective, the value of the company is based on perpetual cash flows or infinite cash flows. Right. You're going to want to make sure that you're protecting the value of the company and so you're going to push the earn out as long as you possibly could. I think from the seller's perspective though, again, you prefer the earn out to be shorter term because that's what you can control.

Is there a percentage amount that you see is the upfront chunk? Is that like a range you typically see?

Look, it's the vast majority every once in a while. And we just saw a distressed deal recently where the vast majority of the consideration was in an earn out. But that's highly unusual. Typically 80, 90% of the deal is upfront cash. Oh really? Sure. Because look, if you were the seller, if you agreed to, let's say the opposite, where 80% was in an earn out, you're essentially handing over somebody else the keys and still continuing to take all the risk of operating the company. Why would you want to do that? It's still a competitive deal environment. As we talked about earlier, finding good quality companies is hard and there's a lot of competition out there with private equity public companies that are all looking to do deals. Even though we might not necessarily think of this as a seller's market per se, not as good as it was maybe over the last couple of years. If you've got a good quality company, there's still a lot of people that are chasing you to invest. The vast majority of the consideration is still upfront cash. And maybe it's a mix if there's rollover equity, but if we're just talking about cash and earn out, it's going to be more cash than earn out.

What's the driver or the point of doing an earn out? We just do the rollover equity instead and call it a day. What's the point of doing the earn out?

Yeah, we see that a lot. Just whatever you're Comfortable with. If you want to continue to be to have a stake in the business going forward, then do the rollover equity. Right. On the other hand, if it's not we're looking to sell or maybe the buyer's looking to buy 100%, you do it through an earn out.

What about the owner? Hold the note? I guess a lot of this stuff I'm thinking of smaller deals if you're dealing with the private individual and it's not as much of the PE competitive market you're playing in.

I was just talking with a private equity client that we work regularly with and they said one of the things that they're looking at is this year is maybe more deals with a seller note. We haven't seen that as much over the last few years. Debt's been cheap and prices and valuations have been high and there hasn't really been the need for that. But he seemed to suggest that we're going to see more of that. One of the items that I always wonder about is just if you're going to sell a company with a really big earn out or with a seller note, you haven't really changed your risk profile. And so why are you doing that deal? Are you looking to get out or in some cases people may be looking to just exit the business. But if you're not looking to exit the business, you're handing the keys to somebody else, letting them operate the company, giving them the upside and you still got all the downside.

That's why you minimize it. So that allocation for either the earn out or the owner financing is minimal.

Yeah.

Not as material. Let's talk about these delayed payments going back to the earnouts. What are they typically based on? Are we talking about top line revenue, EBITDA or just days the calendars fall on?

The vast majority are revenue or EBITDA threshold. You're talking about a revenue or EBITDA threshold every once in a while. I think I'd mentioned when we were talking one time in the past that I saw an earnout that was based on the company's ability to acquire one of their targets. At the time it was like, okay, what's the probability of that happening? And seemed like a very low probability event. And fast forward six months, they did the deal. We do valuations from a financial perspective. The models that we use to value earnouts are complicated. They use option pricing theory and you've got to assess a whole bunch of different probabilities of some event happening at some point in the future. And what's the current value of those future events. But when it comes to something like, oh, this one company and doing an acquisition, there's really no way to do it other than are you talking to them or is there any sort of discussion in process about a deal happening? You can't use option pricing theory on something like that. It's a probability factor.

So you set up this earn out and there's a target to hit. What is it? Is it just simply, you hit this target, you'll get X amount. Is it some multiplier? You get an accelerator on it if.

You get it all of the above.

All the above.

All of the above, yeah. You hit this EBITDA number and we're going to apply a multiple, the difference between the projected EBITDA and this ebitda, or we're going to give you X number of dollars for hitting this threshold. You see all kinds of different structures on how earnouts are organized.

What's the best way to structure it? Top line, bottom line.

If you're the seller, it's top line. That's the most controllable number you have. As a seller, that's probably what you would want. And as a buyer, you'd want EBITDA because that's closer to value and you'd want it as far out as possible. And if you're the seller, you'd want it as close as possible near term.

Why does so many of these turn into litigation?

What happens is that you're aligned going into a deal and you're not necessarily aligned after the deal. It could just be as simple as the selling Shareholders now have a bunch of money and I'm ready to go to the beach or I'm ready to go on to my next adventure, whatever that is. From a buyer perspective, might be like, I don't necessarily look at the business this way. I look at it slightly differently. Or it could be like, wow, there are a lot of issues with this business that I didn't know going into the deal that were kind of smoothed over, you know, at the time we were going through diligence. This is all of our work, not their work that's resulting in performance of the company. Like a lot of things in life, you're aligned prior to the deal, after the deal, I'm not sure how aligned you are. And that naturally results in litigation, I'd say, because one party is going to feel like they weren't treated fairly.

Let's say I'm selling my company. I get a proposal, includes an earn out, teach me how to negotiate that. What should I be doing?

I don't negotiate those things.

Is he enough on the sidelines? Give me an idea of what are some of the key things.

I think competition is good. If you're dealing with one party, it's hard to say what's market because there's a range and having some competition in the process is really good. Knowing what's important to you, whether it's valuation as a whole or what you're getting upfront is another element of it. Because if it's simply no, I think my company is worth X. And if your financials don't support that, then it's like, well, the only way we're going to get there is through an earn out. So really understanding what's driving that earnout. If you feel like, okay, the other parties negotiating in good faith, it's okay. But why is there such a big earn out piece? And if it's simply because there's no competition, then you should have some competition in the process.

Get some competition and it sounds like the timeline. Try to compress the timeline as much as you can.

It also depends on who has leverage. If you're in an industry that a lot of people want to get into, you're going to have more leverage on the ability to push back on terms and things of that sort. Alternatively, if, if you're in a space where lots of people want to get into it, you can dictate your own terms.

Are there alternatives to earn outs? We talked about oil over equity, various earn out structures. Anything else you could do to offset premium?

I mean we do see different incentive plans. So you could have, they're called MIPS Management Incentive Plans. You could have phantom equity, you could have a restricted stock, you could have profits. Interesting. There's a lot of different other structures that you can use to incentivize the management team.

Those are pretty cool. Why don't you put together a little course? You can add that to the MNA Science Academy.

Yeah, we can do that.

Yeah, set something up. Like you got all these earnouts you've already seen and everything. And Ed Hamilton did a course about earnouts. So anybody really wants to do a deep dive about earnouts. There's a course in the M and A Science Academy. It's a little small subscription but it does support this podcast and other things we do. You know he did put a whole course about earnouts. But yeah, if we did one that's brought out to all these range of things that'd be nice to educate the.

Market Happy to do that.

Awesome. Anything else on earnouts that I should know about? Tips, tricks, do's and don'ts?

I don't think so. Keep it simple. Do you trust the other side is important? I'd say both ways to do what they say they're going to do and.

Yeah, stay aligned, trust, keep it simple. I like it. Pj, what's the craziest thing you've seen in M and A?

You know, because honestly we don't get to see a lot of crazy things on our end. You read about things that are going on in the press right now and a lack of due diligence on a recent issue that came about. It does bring me back to a company that I worked with. It was probably about 15 years ago who did a really big transaction. They were in the CRO space and they didn't want to pay for diligence. I said they ended up doing the deal, not going through diligence. Literally the day after the deal, the FDA came in and closed down the facility. And it was a decent sized transaction, 250, 300 million 15 years ago and instantly that value evaporated. So that's one thing that kind of came about earlier. I was talking about the story aligning and that. I remember another time working with a company, we were doing a lot of transactions with them. They were doing a roll up and gosh, they were doing 10 big deals a year. And this one transaction that they were looking at, Target Co. Had brought in a new management team. And it was the first time, I would say, maybe the only time, where I just felt like the management team had no idea what was going on the business. I think they thought that they could bring in this group of people that could talk well and maybe be able to get through the sales process, but they didn't know the business. In those days we used to go on site. We were on site for a couple of days and felt like we came back with no additional information. Those are two things that I think come to mind.

That's pretty bizarre.

Yeah, yeah, it is. Because if you're in the business, you know the business. In this case, it wasn't what came out of it. The company still went ahead and did the deal, but got rid of the people that were in those positions right away.

Had some faith. That first story I would see 29 crazy stories. That was pretty damn crazy. Look at the good lesson there. Do your diligence. That was a lot of value to lose.

Yeah, exactly. These things can be expensive, but it's worth it because that pays for a lot of diligence to lose that kind of money on one transaction just because you didn't go through the proper steps.

Ej this has been great. Thank you so much for taking the time today. I appreciate you helping me become a better M and A scientist.

Thanks Kasan. It's fun. I appreciate you having me on and look forward to doing more with you guys.

Hey, those of you still with us, thank you for hanging out in until next time, here's to the deal. Thank you for taking the time to explore the world of M and A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M and A function or optimizing one that you you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email Kisan K I S o n a science.com or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter. Again, that's mascience.com here's to the deal. Views and opinions expressed on M and A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.