Structure an earnout for this deal

June 12, 2023

by a searcher in Cincinnati, OH, USA

Despite increases in revenue earnings were impacted by the margins being squeezed, Adjusted EBITDA for 2022 was a loss, TTM is basically $0/breakeven, and too early to predict if 2023 earnings will be positive. Company expects the low margin work to be completed Q3 and higher margin work to return in Q4.

Debt doesn't seem appropriate with earnings in flux. Looking for suggestions on structuring an earnout.

2019: $3.75M Revenue / (-$175K) Adjusted EBITDA
2020: $5M Revenue / $325K Adjusted EBITDA
2021: $5M Revenue / $395 Adjusted EBITDA
2022: $5M Revenue / (-150K) Adjusted EBITDA
TTM: $5.8M Revenue / $0 Adjusted EBITDA
Projections: $6M Revenue / TBD Adjusted EBITDA

Balance Sheet (Major Items):
Assets
AR: $900K
Inventory: $1.2M

Liabilities
Customer Deposits: $1.1M

How would you structure an earnout.....or is there no choice but to wait for TTM earnings to return, so debt is an option?? Looking for any suggestions.

Reply by an investor
from New York University in New York, NY, USA

This seems like a tough one to finance with 3rd party debt any time soon. Even if you look at###-###-#### , margins were ~7%. If those were “normal” margins, it seems like it will take a while for TTM to return to meaningful levels. And even then - you might have a decent EBITDA for TTM at some point in 2024, perhaps breakeven for 2023 and a loss for###-###-#### There are many people on searchfundder that have more expertise on this topic, but that looks like a tough credit story to me. If the seller wants to get a deal done any time soon, I would put the financing on them. Depending upon your level of confidence that this situation will turn around, you could put in some amount of equity upfront, then put the rest as an earnout, contingent seller note, or some combination. I’d be careful about how much equity goes in as you would really be taking a risk when things have not turned yet. Depending upon the seller’s situation, perhaps something like this could work, though they might just decide to just hold on selling until things turn around so they can get more cash upfront. No silver bullet offered, but hope this helps!

Reply by a professional
from Lancaster University in London, UK

Earn-outs are often used in scenarios where (at least one party feels) that current performance doesn't reflect the true value or potential of a business. It sounds like you have this here. I would suggest that the way to look at this would be to compare what you think the business is worth right now against what you would pay if the company's EBITDA projections were actuals. That difference is the potential earn-out pot. I'd argue this should be discounted to account for the work you will do as buyer. Once you have the pot you can agree thresholds for the seller to achieve this. This can be an all or nothing arrangement where if the EBITDA target is not achieved in full then the seller receives nothing, or the earn-out can be drafted so that a proportion of the earn-out pot can be achieved by the seller if the company hits a proportion of the target. I'd always suggest a longer than 1 year earn-out period or multiple periods so that you are not paying on the basis of an unusual year. NB. I have referred here to EBITDA as an example only nothing that EBITDA is not the metric for valuations/earn-out targets.

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