As a very frequent buyer of companies, Cheryl Strom, a Partner at The Riverside Company, says the primary risk that they're looking to mitigate is the deal falling apart.
"We may have spent months and even years trying to bring an opportunity to the finish line," Strom says. "(I'm) working on an indication of interest that we're going to submit soon for a company that I've personally been cultivating for over six years. Being an effective buyer requires staying in touch until the owners are ready to have that transition in ownership. So, what are the reasons that people sometimes spend months and even years trying to complete all the stages of a deal, and somehow at the end, it falls apart?"
While there may be 100 answers, she finds they all fall under two big umbrellas, each of which have many causes. One is that the financial performance of the company changes in some way that it doesn't meet its forecast, usually through a shortfall in performance — one reason, many causes.
The other big-picture reason is that somewhere along the path toward reaching a closed transaction, either the buyer or the seller has changed their viewpoint in either interest or desire to reach the finish line.
Often these reasons can be prevented by preparation.
"Preparation leads to speed and certainty in all the steps," she says. "There's a big difference in a transaction reaching a finish line in 30 days and somehow spanning out over nine months. Proper preparation means your financials are in order, you can answer questions about the different types of revenue you have, you understand whether a customer that's an important customer is going to stay a customer in your forecast period. Having accurate information requires involvement of many people on your team. It may sometimes require changing people on your team to have the caliber of experience needed to accurately forecast a business and prepare for a sale. But with proper preparation, you can shorten the time from receiving an offer to close, and you can reduce the possibility that the buyer changes course because things are different than initially presented or expected."
Earn outs come in and out of favor as the M&A market fluctuates and are used when buyers want the owner of the company they're acquiring to stay on as a meaningful owner of the business post-transaction, bringing in resources to then transition the business over a period of time. In that case, an earn out she says, isn't really necessary, because that operator is staying a meaningful shareholder. But all owners have different objectives, reasons and prompts for wanting to go through their transition.
It was more common a few years ago with the M&A market was frothy for owners to fully exit, receive all of their cash right then and not be concerned with what happens to the business after. In today's market, earn outs are very much an active part of every conversation.
"Buyers are a little bit more cautious and wanting to be careful that they don't enter into a situation where a forecast can't be met and they're sitting there holding the bag with something that isn't turning out as expected," Strom says. "So, keeping a seller involved structurally is certainly something that helps us de-risk from our side."
Earn outs are becoming more commonplace and more accepted in the market as they're more frequently deployed. And that can be good, if they're thoughtful before accepting it.
"If you're a seller and an earn out is part of the equation, you want to look with much more care and scrutiny at who is this buyer?" she says. "What are they going to do? What resources do they have? What is my likelihood of succeeding and growing the company enough with their involvement in collaboration so that I actually achieve this earn out?"
She says Riverside loves paying earn outs. They're a good thing for everybody because it means that the company achieved its forecast. They're also a way to either add extra value to the equation, or to delay some of the valuation. However, she advises that it also takes a very good attorney to document, and a lot of clarity.
"Things can go wrong," Strom says. "What does it mean? Is it based on revenue? Is it based on profit? What about cross sell? Am I being integrated into another company? Am I being forced to take on costs I didn't expect because I'm going through a combination? Those are all important questions to answer and to feel comfortable with. And also, check on the reputation of the buyer who you're working with and what have they done in the past? Have they paid earn outs in the past successfully? Have there been conflicts? Be comfortable with the answers to those questions as you proceed."
