Any recommendations valuing/structuring deals with annual contracts?

June 20, 2023

by a searcher from College of William and Mary - Raymond A. Mason School of Business in Nashville, TN, USA

I have seen some companies in B2B services that have annual contracts. Is it reasonable for a seller to try to create a valuation based on future (contracted) performance? If so, how could that be structured?

- Revenue (contracted) increase from now to end of year, as an example let's say 25%.

- EBITDA (forecasted) increase from now to end of year, as an example, let's say 40%.

My initial thought would be to do create an offer based on TTM EBITDA (that is what I have seen as somewhat of a standard on many services transactions). Could I include an additional earn out to get close to forecasted EBITDA?

I have seen a few deals that have aggressive pro forma numbers not in line with historical (actual) financials. I am thinking in a case like this that due diligence (including a QoE) will uncover the actual contracts (allowing me to eliminate any unsubstantiated forecasted improved performance).

Any recommendations on structuring? Or other general concerns? For assumptions, let's pretend this is in the $7-15M price range.

Thanks!

Reply by a searcher
from The University of Michigan in 1075 Gills Dr, Orlando, FL 32824, USA

Clayton, I think an earn out would be a reasonable structure. My business signs contracts that last many years and we often sign contracts with new clients for work/revenue that is further than a year out. If they have an effective sales process, particularly if they have improved it or invested in it recently, it's reasonable that they could have an increase in contracted revenue for the near future. Having said that, anything can happen between now and when that work is scheduled to be done so I wouldn't pay for it upfront, I would make that value contingent on the revenue actually being earned at the future date. In other words, the payment to the seller at close should reflect past earnings and there should be an earn out if the projected revenues come to fruition. If you're doing an SBA loan, they won't allow earn outs but you can structure it as a forgivable seller's note to accomplish the same goal.

Reply by an member
from Western University in Toronto, ON, Canada

Valuing and structuring deals with annual contracts can be complex. You can consider using TTM EBITDA as a baseline and incorporate an earn-out to bridge the gap with forecasted EBITDA. Thorough due diligence, including a Quality of Earnings analysis, is crucial. For the $7-15M price range, a combination of upfront payment and performance-based earn-out could work well.

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