Case Study:

We recently were retained to sell a business that had just completed a significant facility expansion. The principals of the business had used all their equity, and borrowed heavily from their bank in order to finance the approximately $5 million dollar facility expansion.

They quickly found themselves in financial difficulty as a result of a lack of working capital to finance the future growth anticipated by the expansion and even though the market indicated it was ready to provide more orders further capital spending of ½ million dollars is now required for packaging equipment to meet the new needs of customers as a result of the changes the economic times was imposing on those customers.

While still profitable, the capital repayments required under the financing agreement with the bank was causing cash flow problems and restricting the business' ability to finance receivables and acquire more inventory. More simply put: "The company was overtrading its equity".

The expansion of the facilities gave the business the capacity to increase revenues on one shift to between $30 to $35 million dollars depending on product mix and timeliness of orders and on two shifts, to between $50 and $55million dollars, but working capital was restricting growth.

The purchaser's value of the business was based on future discounted cash flow, but did not consider the growth potential of the business with proper financing. In fact the value was about the same as book value, and it appeared the clients had little choice but to sell at that price.

Enter the earnout. The buyers conceded that the sellers had positioned the business for rapid growth and agreed to share some of the future profits if they occurred, with the seller, provided that the sellers agreed to remain and operate the business for the purchaser. The earn-out worked as follows:

On all revenues over $15 million dollars, a royalty payment of 3.5% was to be made provided the gross margin remained at past levels. The royalty program was to remain in effect for seven years after closing. The purchaser's rationalization for this was that at $15 million in revenue at historical margins, they would earn a satisfactory return on their investment.

It became apparent to the purchasers throughout the negotiations that they needed the sellers to realize the revenue potential and to be able to operate the facility profitably at higher volumes. It is believed by the owners that the earn-out provides them with the potential to double their selling price over the next seven years. Ii quickly became obvious to all that an earn-out was a win-win for both parties.