Earn-out agreements are useful but contentious tools in M&A transactions to bridge disagreements. In an earn-out, the seller agrees that a portion of the deal consideration will be contingent upon the future performance of the company.

Sellers must participate in estimating their earn-out expectations and in due diligence of the likelihood of collection. The possibility of payout is increased by:

• Confirm buyer’s creditworthiness and ability to run the business.
• Verify the buyer’s plan for operating the business.
• Ensure the formula for earn-out payments is clearly specified and that you have the right to examine financial information related to the earn-outs.
• Understand buyer’s plans that may endanger key customer and supplier relationships, employee retention or the company’s cash flow.
• Make certain the earn-outs are beneficial to the buyer.
• The earn-out period should be less than two years.

At the end of the day, getting paid depends on the reputation and character of the buyer. Experienced M&A professionals will ensure the sellers understand the potential reduction of earn-out compensation from buyers’ post deal remorse, misinterpretation of provisions, “management” or possible manipulation of financial results.

The mergers and acquisitions (M&A) sales process begins with the preparation of a thorough Offering Memorandum (OM). This critical document provides the framework for profiling a company and positioning it for sale.

An effective OM requires collaboration between the Sellers and the M&A advisor to capture the essence of the business. These conversations will include:

• Company overview – history, who we are, what we do
• Define the core business – processes, technologies
• Strengths and weaknesses – success factors, opportunities, challenges, shortcomings
• Description of the industry & competition – market analysis
• Financial and/or contractual obligations
• Description of the work force – key executives/managers, backgrounds, personnel
• Major contracts and customers
• Normalized and recast financial statements – including original statements prepared by an independent CPA

A properly prepared OM should summarize essential business information with the intent to engage numerous prospective buyers in a negotiated sale of the business. The OM will serve as the backbone of the negotiations process; providing a clear and detailed story, ensuring a successful transaction.

There are four types of valuations used to understand middle market transactions and helpful with succession planning:

• Fair market value, hypothetical concepts, most commonly used in estate, income and gift tax planning or litigation support.
• Preliminary estimate of value in the market-place; will include strategic values recently paid in an industry.
• Investment value, value particular to potential buyers.
• Final transaction value, actual value paid in a closing transaction.

The use of a valuation may be the catalysts for business owners to operate their companies in the most value-enhancing manner. In the future, the market may be over-crowded with companies for sale; the opportunity to create significant owner-value should begin immediately. Experienced investment bankers should be able to advise sellers as to general price ranges, and identify positive and negative value drivers so as to maximize the final transaction value of the business.

Lackadaisical buyers or “Tire Kickers” waste everyone’s time and money and should be avoided whenever possible. These casual buyers may be curious but lack the commitment to close, lack the resources to make an acquisition, have the resources but unsure of the type of business, looking for a deal but far below market value, or just plain snooping with no intention of acquiring a business at all.

With the assistance of an experienced M&A Team, sellers can be certain that potential buyers will be vetted for their commitment to close. On the front end of a deal, potential buyers should:

• Define their criteria for a purchase decision
• Identify their sources of funding
• When would they like to close the deal?
• Are there any deal-breakers?
• Other companies under consideration?

A committed buyer or ideal prospect knows exactly what they want, should be able to give specific reasons for the acquisition, can run the business effectively, has the financial capacity to acquire, and is willing to sign a non-disclosure agreement.

Currently, in the M&A community, discussions regarding the purchase price of a target company are most often expressed as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). If EBITDA is the benchmark, what is the justification for such a wide range of transaction multiples from 3-4-5 to 8-9-10 in the same or different industries? It is particularly important that buyers and sellers understand the concept of actual free-cash flow. The most accepted measure of free-cash flow is EBITDA less Capital Expenditures (EBITDA-CAPEX).

When considering an acquisition, the analysis of CAPEX is essential. CAPEX may be separated into two categories:

• Immediate expenditures required to bring the operating assets into good working order; and
• Ongoing annual, recurring reinvestments for existing operations or for revenue and earnings growth.

The choice of multiple(s) depends on the nature of the business. Service companies normally require very little capital re-investment, and as such, EBIT (Earnings Before Interest & Taxes) is an appropriate cash flow metric. For capital intensive businesses, EBITDA-CAPEX is more appropriate, since it accounts for the necessary capital reinvestment to maintain and grow the business.