The formulas, tricks and trade secrets of Private Equity
Funding Earn Out
So, a typical deal may sound like… I’ll pay you $x for your business, of which $y is paid now and $z is paid if you meet next year’s EBITDA budget. The $z, which is predicated on future earnings, represents an earn out. That is, the vendor has to earn that additional capital payment by hitting budget. I’ve written about funding earn outs many times before, which you may like to visit before continuing:
Are earn outs fair… or just a product of private equity avarice?
The value-based components of a private equity deal
Unpaid earn outs and discontented vendors
But, when the time comes and the business has exceeded its EBITDA target, where does the money come from to pay the vendor to finance the earn out? If you’re buying 100% of the business, the vendor doesn’t really care where you get the cash from (as long as it is paid) because they no longer have an interest in the business. However, if the vendor is retaining a share of the business or if there are other shareholders remaining in the business then they will certainly care about funding the earn out.
Let’s use an example. If I pay you $100m for 50% of your business, but $20m of that is earn out financing (so $80m up front), you may assume it’s all coming from my own pocket (or the bank’s). But, what if I suggest the company’s cash flow covers the earn out? Well, since you will still own 50% of the business, you will essentially be paying $10m of your own earn out.
Now, this isn’t necessarily a deceptive term suggested by the buyer; it’s simply a valuation play. Of course this structure would be disclosed upfront for you to analyse, so all I’m saying here is that it’s an interesting way to adjust value in a deal to meet conflicting expectations. In the above example, you would receive $100m if the business met budget, but theoretically $90m is from my pocket and $10m is from your own. As long as you think of it this way, there’s no issue.
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