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This blog covers earnouts in M&A deals.
Earnouts are becoming more and more common in M&A deals. While before relatively rarely used in non-life sciences deals, earnouts appear in around 25% to 50% of M&A deals today. Earnouts are more common when the individual seller is tied to the success of the business. Earnouts in effect double as the bonus compensation given to individual sellers in their employment agreement with the new company. However, earnouts seem to be becoming a smaller percent of aggregate consideration. A few years ago, some deals had 33% of the purchase price tied to a successful earnout. Today, it seems like it is closer to less than 20%. The percentage does increase if the individual seller is tied to the success of the business.
The most common metric is revenue followed by EBITDA. Sometimes, specific items trigger a realization on an earnout. If so, the amount of the escrow could be higher. Depending on the metric, earnout can be very short or up to three years.
There are several things a seller should consider when negotiating an earnout.
1) The realization of an earnout is often out of the seller's control. It is tied to how the buyer runs the business post-closing. That is frustrating to the seller. Sellers can negotiate to make the buyer obligated to run the business to maximize the earnout payments. This clause can be worded to mandate the buyer to devote sufficient resources to maximize the earnout, such as new hires and incentivizing current employees to sell the target business. If EBITDA is the target, sellers need to be aware of the new business' expenses and their effect on profit.
2) Does the earnout accelerate upon a change of control? This is often a tricky issue in negotiation. Buyers hate the provision because it causes them money when they turn around and sell the new business. However, there is a logic to it from the seller's point of view. A sale of the new business is generally associated with the success of the new business. Why shouldn't the seller share in such success?
3) Can the buyer offset indemnity claims against future earnout payments? This provision is fairly common, even though more sellers are successfully resisting it. The compromise is that the earnout payments are tolled if there is a dispute. This has the effect of increasing the size of the indemnity escrow.
4) Cash is still king. Earnouts are always risky, even if the targets seem easy to reach. Forecasts cannot be met for a multiple of reasons. Taking a lower aggerate purchase price may be worth it if the cash at closing is greater.
5) The time period for an earnout has to be the same length or shorter than the individual seller's employment agreement with the new business. The seller needs some input on whether the new business can achieve the targets in order to be able to maximize the earnout.
If you are negotiating an earnout in the sale or purchase of a company, please contact Rob Marks of Tomlinson Advisory Group at firstname.lastname@example.org.
This blog covers recent trends in M&A for small, early stage SaaS companies.
According to a Software Equity Group's recent report, First Quarter 2019's 277 SaaS M&A transactions marked another record quarter of deal volume. Small to mid-sized companies (less than 100 employees) continue to make up the majority of acquisition targets. Healthcare is the top field, followed by education, real estate and finance. As to products, there were significant transactions in content, document and business process management software and marketing and technology (martech) software.
The increase in M&A activity is driven by the fact that technology is a product-driven business. Products have cycles, and revenues track cycles. Therefore, technology companies are always looking to invent -- or acquire -- a new product on the growing side of its cycle. Synergistic M&A is necessary for existing players to remain competitive and grow. For smaller players, the end game is often a purchase by large strategics like MicroSoft or Salesforce looking to add to their platforms or by other product developers looking to expand their niche product offerings.
Traditionally, PE firms shied away from early-stage software companies in favor of later stage companies. They would then drive up profitability by cutting costs and inserting their own management. The end game was to sell or take the company public in a few years to generate a return. Now funds put capital into these companies to hire sales forces and improve and expand the platforms. This increased attention is good for SaaS companies as PE funds pay similar multiples as strategics. do.
To be an attractive candidate for M&A, a SaaS company should maintain at least 20% year over year growth with at least 90% of that revenue coming from contracted recurring streams. Recurring streams are key as profit in the future will expand materially as the business matures and spends less on development, sales and other costs. SaaS companies should strive for a 30%+ EBITDA margin. If you’re not profitable, growth needs to be well in excess of 20% to offset weaker EBITDA. Lastly, qualitative factors such as the age of the software, the necessity of the management team, customer acquisition cost, the uniqueness of the product and competition are taken into account .
Multiples for small, early stage SaaS businesses typically fall within the 2.5x to 4x revenue. 4x businesses are around 3+ years old, need less than 10 hours per week of the owner's time to maintain, have growing revenue and have lower customer acquisition cost. 2.5x businesses are less than 2 years old, need 20 hours or more per week of the owner's time to maintain, have steady revenues and require high customer acquisition cost. However, every business is unique.
On the other hand, I have seen multiples for established SaaS companies with synergistic, attractive customers receive multiples of 20x revenue, but such multiples require significant earnouts to realize full purchase price.
Now is a good time for a SaaS company to consider M&A while the industry is hot. Timing and speed are key as buyers have plenty of alterative companies to pursue to achieve similar objectives. This is especially true as a hot software solution today may be obsolete by new competition tomorrow.
If you are interested in buying or selling a SaaS company, please contact Rob Marks at email@example.com.
Tomlinson Advisory Group, LLC works with clients new or inexperienced in raising institutional money, whether from private equity, venture capital, high net worth individuals or otherwise.
Here are tips to getting your first institutional money:
1. Raising Institutional Money is Plan B
2. 3 Keys to Raising Outside Money: Management, Management, Management
3. You are not Selling your Business, You are Raising Money
4. MONEY: How much do you need? What do you need it for? When do you need it?
5. You are Selling a Balance Sheet
6. You are Making a Securities Offering
7. Get Help with the Terms of Your Offering
8. Tie Valuation to Security Offering
9. Conduct Reverse Diligence on Your Company
10. What Role Do YOU Want?
Tomlinson Advisory Group, LLC helps its clients reduce risks association with transactions, control costs and accelerate timing. The goal in each transaction is for the client to achieve a higher price with more certainty.
Here are tips to closing a successful transaction: