IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Oliver Kotelnikov. Mr. Kotelnikov, is a senior business brokerage intermediary at IBA (www.ibainc.com):

Tools of the Trade: Bridging the Value Gap in the Sale of a Business

In an entertaining True Hollywood Story, actor Ryan Reynolds recently sold his gin company, Aviation American Gin, for a cool $610 million.  The purchaser was the world’s largest spirits distillery Diageo, the maker of Johnnie Walker and Guinness among other brands.  The buyer delivered a check for $335M, which caught the actor by surprise. Post closing, Mr. Reynolds is said to have received a crash course from his advisors on the topic of deferred, performance-based compensation commonly utilized in a sale of a business.  The buyer negotiated a variable component into the deal including a $275M earn out over 10 years as part of the purchase price. The movie star was later quoted as saying that he just learned what an earn out is and that apparently, he will still be busy selling Aviation Gin for quite some time.  He also lamented that he isn’t quite as George Clooney as he thought he was, referring to his colleague’s recent sale of his tequila brand Casamigos for a flat $1,000,000,000.  This altogether larger, but a similarly structured transaction also utilized an earn out reportedly paying Mr. Clooney and his partners $700M in cash and deferring the remaining portion of the purchase price to be paid out over a period of time provided targeted growth is achieved.  The fixed amounts of cash received by both sellers for their distilling businesses are impressive. The backend details and transactional principals utilized to successfully complete these  transactions have a high degree of carryover to the businesses in the main street and lower middle market sectors and provide a valuable lesson to entrepreneurs considering an exit strategy in the near future.

Earn outs are an effective tool to help willing parties reach agreement in a transaction by equitably allocating the risks associated with the change of ownership and accurately assessing the value of a business in unstable market conditions.  Commonplace concerns for the buyers include maintaining profitability, preserving the goodwill of the business, and minimizing the effects of loss of the personal goodwill of the departing owner.  Sellers want to receive top dollar for their business based on historical performance and avoid the value being diluted by unique economic events and cyclical recessions.

Business Goodwill

Goodwill of a business can be defined as a positively charged, economic force field that surrounds the company’s position in the marketplace.  It’s an onion.  The outer core is the financial success of the business represented by the willingness of the customer demographic to continue supporting the company with their dollars.   The deeper layers responsible for this desired result are brand recognition, reputation, accepted and proven value proposition, a unique identity differentiated from the competition, and ultimately trust.  At its core, goodwill is the result of a deep emotional connection that the business has built with its customer.  Convenience and necessity business models aside, we don’t buy because we have to.  We do so because we trust, admire, recognize, and relate.  Goodwill, or the intricate, authentic rapport between the company and its customers, takes time and effort to build, and acquiring this valuable commodity is often an entrepreneur’s sole justification behind paying a premium to purchase an existing business rather than starting something from scratch.   But it’s as potent as it is delicate.  At its most fragile in transit, this precious cargo can easily be damaged when the business is changing hands.  Buyers will frequently take out extra insurance in the form of an earn out and make part of the purchase price contingent on future performance of the business.   The “Skin in the Game” tactic incentivizes the departing seller to in good faith deliver ALL the ingredients of the recipe that make the business a success including operational infrastructure, key relationships, and the intangibles and tacit knowledge that may or may not be noted in the operational protocol manuals.

Personal Goodwill

Personal goodwill becomes a deal point in the transaction when the product or a service sold by the company is closely associated with the owners’ persona in the eye of the public.  Neighborhood residents may lament the retirement of the founder and longtime owner Joe Smith of Joe’s Plumbing, but if the new operator continues to deliver on the promise of price, service, quality, and the overall value proposition, customers are very likely to continue using Joe’s for their plumbing needs.  Tony Robbins, on the other hand, would have a hard time replacing himself as the brand ambassador of his global personal empowerment enterprise and continue charging top dollar for books and seminars.  In the above case study of the celebrity distillers, the buyer correctly identified that the personal goodwill of the globally recognized actor cannot replaced or reassigned, but the business can continue to thrive if the  owner is retained post sale and remains in the strategically key position as the spokesperson for Aviation Gin. The earn out likely took on the form of a minority share in the ownership of the company, a profit sharing agreement, or sub-contractor/employment agreement to retain the actor as the face of the company and insure continued appearances in the marketing campaigns for the product.  $275M of the $610M total would be paid out as a percentage of revenues over 10 years if the product sales clear preestablished revenue hurdles.

Valuations in Unique Market Conditions

While most businesses will transition for fair market value under standard market conditions, pronounced peaks and troughs of the economic cycle will introduce elements of uncertainty that can disproportionately impact how buyers and sellers perceive the value of an otherwise established business.  Viewed through the lens of a temporary economic downturn, buyers are likely to undervalue an established business by downplaying historical performance and highlighting recessionary indicators. Sellers exiting in a strong bull market will often overvalue their businesses by emphasizing potential future earnings.  Incorporating a variable compensation piece into the structure in the form of an earn out can get the parties to yes if they agree to let the market speak and true up the value of the business over time.  The seller caught in a recession can still exit as planned receiving the portion of the proceeds that reflects the business value under current market conditions upfront, and be made whole over time if and when the business rebounds.  The buyer coming in at peak harvest can purchase a business at fair market value and compensate the seller for the growth premium portion of the purchase price in the future provided such growth materializes.

Earn out agreements must be intelligently engineered and limited in scope and duration if they are to be effective and serve the intended purpose.  Loosely structured, they can become an invasive species and expose both parties to unnecessary risk and liability.  If the seller “floated” the buyer the portion of the business value associated with the temporary, negative effects of the COVID pandemic, they should not be exposed to or damaged by new ownerships poor managerial decisions or ill-fated cost saving tactics.  On the flip side, the seller’s reach should also be limited to recouping the value lost due to COVID and stop short of becoming a royalty program or a mechanism to tax all future growth of the business.

If you have questions relating to the content of this article, the process associated with preparing a business for sale, or establishing the market value for a privately held company or family business, Oliver Kotelnikov would welcome the opportunity to talk with you.  Mr. Kotelnikov can be reached at (425) 454-3052 or oliver@ibainc.com.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.