On the sell side, Gordon Rees LP National Chair Business Transactions Sections Craig Heryford says he’s seen the use of earn outs shift a bit. The trend in 2022 and 2023 he says was equity sponsors and the market being as creative as they could to bridge valuation gaps. There were significant rollovers, earn outs, and people going back to using seller debt. While those trends have shifted somewhat, rollovers and earn outs are still a common practice today.
“Really seeing valuations come down and more deals where people are willing to say, ‘We want to roll over,’” Heryford said at the Pittsburgh Smart Business Dealmakers Conference. “I'm seeing a lot of rollovers still in transactions, and that's a really important thing to focus on. But we're seeing more just, here's what we'll pay for this business, maybe an earn out to bridge it, but a simpler structure.”
He says this trend can be explained in part because there are fewer deals going to market, which he attributes to the cost of money, as well as another prominent factor.
“I think there's a perception, certainly among sellers, that valuations are down and they don't want to go out to market when they think they're leaving money on the table,” he says.
What he says he sees quite a bit now on the buy side is more attention paid to downside protection. That shows up in the increased amount of diligence and emphasis on quality of earnings.
“QofEs used to be a check the box, let's get it done — our lender wants to see it, we want to see it for underwriting. It's serious now,” Heryford says. “And there are offshoots of diligence, financial diligence, that I'm seeing happen that were not nearly as prevalent in prior markets. Discussions around networking capital can be very lengthy discussions now. People want to make sure there's cash left in the business. They don't want to draw down on a line on day one to fund the business.”
On the sell side, there is more time spent on getting a detailed letter of intent.
“It's not that people are trying to say, ‘Gotcha.’ It's always been the devil in the details,” he says. “But the details people are drilling down on more than (they) used to.”
For example, he says an LOI should clearly define what an owner is rolling into. That’s because while some equity sponsors will roll an owner over into the same level of equity that they have, other sponsors take more of what he considers to be a venture capitalist approach. In the latter case, they have a preferred level of equity, get their money out first, get a return on their money first, and then the rollover money gets paid.
“That's a very different deal,” he says. “You may want to do that deal, ultimately, but the value of your rollover just went down significantly. So, you need to understand those things.”
So, while earn outs can be mutually beneficial, he says owners need to think about the bigger picture.
“I always counsel people, please be happy with the upfront purchase price because you don't know,” Heryford says. “Don't spend the earn out. You don't see many yachts named ‘Earn Out.’”
