New Venture Lab: Equipping Christian Entrepreneurs

Question

I've read through the Q&A postings relating to valuation of an existing business for purchase and appreciate the information you've presented.  I wonder if you might elaborate on how pricing should be adjusted in light of the increased risk present under our current economic environment.  Are there any standard, forward-looking adjustments.

Answer

There are no standard forward-looking adjustments, but there are a few good ways that buyers often manage the risk you describe. 
First, a little bit about the Seller’s motivation.  Sellers will often offer up their plan for the next year, but they are usually very optimistic as they are trying to present their company in the best possible light.  I am currently looking at potential acquisition where the five-year history of sales has been absolutely flat -- with no growth whatsoever -- but the Seller’s 2009 plan shows a 40% growth.  And the Seller further wants an additional premium for the company based upon its new product development “potential.”  This is not a very credible scenario.  So the Buyer of the company (that starts off knowing nothing about the company, its products, its competitors, its customers, its strengths and weaknesses, etc.) is going to dramatically out-perform what the Seller (who has near perfect knowledge of the company) has been able to do in the past five years running?  I don’t think so.

Now, back to the Seller and managing the future risk in an economic downturn -- start with the current "market comparables", that is, the average price that companies in the target industry are current getting on a multiple of earnings basis.  More on that is posted here.  Given that, the three methods I use to perform the due diligence and manage the risk are: i) a sales pipeline analysis, ii) a contingent earnout, and iii) a clawback:

• Sales pipeline analysis -- Ask the Seller for details on their sales pipeline metrics, such as how long it typically takes to sell a customer from lead to closing the sale (sales cycle time); the conversion rate from lead to customer (win rate); leads by lead source, etc.
  • If they cannot furnish that type of detail, your due diligence has at least uncovered that either they do not have the data or they lack the analytical rigor to crunch the data – a much riskier scenario than if they have the data and can analyze it and can act on it.  If you do move forward with an acquisition without this information, not only do you not know what you are getting into, but your investment in creating the capability will take time and money and should be factored into the purchase price.
  • If they can furnish the information, look for recent trends to discern whether or not there is any drop off in the number of leads or any lengthening of the sales cycle time, either of which would signal a weakening in the sales pipeline and lower future sales.  Based upon their current win rate and their current pipeline of leads, you can easily forecast future sales and therefore get a better forward-looking picture.  You can then adjust the purchase price based on the lower projections.
• Contingent Earnout -- An Earnout is the situation where the Buyer negotiates part of the Purchase Price to be paid in the future (usually on the anniversary of the Closing Date) based upon some performance metric -- usually Revenue or Earnings.  This is “contingent” because if the company does not perform to the metrics agreed upon, the Seller does not get paid the Earnout.  This is very common practice and I have rarely ever done an acquisition without an Earnout in one form or another.  This shifts some of the risk or uncertainty to the Seller, who has much more perfect information about the company than the Buyer, as already noted.  In normal economic situations, it is common that 10 - 25% or even more of the Purchase Price consists of a contingent Earnout.  In order to adjust for additional future economic uncertainty, I would suggest that you negotiate less Cash at Closing and more in Earnout than is common in the industry in which you are targeting your acquisition.
• Clawback -- A Clawback works in a similar way to the Earnout, but allows the Buyer to “clawback” proceeds already paid to the Seller under certain scenarios.  Obviously this is harder to orchestrate in actual practice, since the Seller has already received the funds and this demand for cash back can cause the Buyer and Seller to get embroiled in a nasty lawsuit.  Most acquisition documents, usually called Purchase Agreements, do contain Clawbacks for issues of unforeseen liability and they are usually tied to the Representations and Warranties made by the Seller.  Clawbacks, though, are not the normal practice for managing future uncertainty in terms of the company’s Revenue or Earnings performance -- that is normally managed through the use of Earnouts.