How to buy an inventory heavy cyclical business?
February 08, 2024
by a searcher from Harvard University - Harvard Business School in Westchester County, NY, USA
Suppose there's a seller who fits so many of the "searchy" criteria for a great deal. Suppose the profits of the seller's company vary tremendously - about $2m+ EBITDA on average, but due to the cyclical nature of the business model, some years are extremely profitable and others not so much, though the only loss was one year due to COVID shutdowns.
How would you finance something like this? Earnout? Contingent seller note? Equity roll? Where would you learn more about how to structure a deal?
from Bentley College in Miami, FL, USA
An earnout is a great tool for bridging valuation gaps, especially when future performance is uncertain. It allows you to pay the seller a portion of the purchase price based on achieving future performance milestones. This can be particularly effective in your scenario, as it aligns incentives and helps mitigate the risk of future downturns.
Pros: Aligns seller and buyer interests post-acquisition, offers protection against overpaying for future performance that doesn't materialize.
Cons: Can lead to disputes over milestones or earnout calculations, requires ongoing monitoring and potentially complex agreements.
Contingent Seller Note
A contingent seller note is another way to handle the unpredictable nature of the business's earnings. Payments on the note can be tied to the financial performance of the company, offering a form of protection against downturns.
Pros: Provides flexibility in financing, seller retains a stake in the company's success, potentially easier to negotiate than an earnout.
Cons: Interest payments can strain cash flow in lean years, and the need for clear performance metrics to trigger payments.
Equity Roll
Having the seller roll over a portion of their equity into the new company structure can also be a savvy move. It keeps the seller invested in the success of the business, potentially smoothing over concerns about the cyclical nature of the company's performance.
Pros: Keeps the seller's skin in the game, potentially reduces the cash needed upfront, and aligns long-term interests.
Cons: The seller remains involved, which may not be ideal for all buyers or sellers, and disagreements on future direction can arise.
from Bowling Green State University in Surrey, BC, Canada
As well, you may want to think about ordering up an inventory appraisal as part of the deal - there are firms who specialize in these and can provide an estimate of FMV. orderly liquidation value, and forced liquidation value. If that's a hill too far, well, at minimum talk to your potential bank partners about an operating line of credit and what sort of margining might be available (ie. 75% of AR, 50% of inventory, etc.). Then, you might be able to utilize a portion of the Line for closing.
On valuation, well, yeah maybe an earn-out is an option but hopefully the valuation will reflect an average of those good and bad earning years. Funny, I heard a lawyer recently say, if you use an earn-out prepare for litigation - obviously, not a fan.
Better, in my opinion, to really focus on that working capital piece and valuation of the inventory, and sector dynamics, the fundamentals - for example, overstock is an issue in some goods sectors right now - talk to their customers, how's things look down the daisy chain.
Just a few quick thoughts - good luck