Think BR: What's the point of an earnout if the economic gloom persists?
Who, other than the owners of a company in distress, will want to sell their business under an earnout deal if the upside is so uncertain, asks Bob Willott.
Bob Willott: editor of Marketing Services Financial Intelligence
With the whole world seemingly gripped by economic uncertainty, the corporate acquisition market in the UK must be going through a lean time.
Of course there will always be deals to be done, particularly by bargain hunters seeking out distressed sellers.
But for marketing agencies with a strong growth record whose shareholders would have been looking for an exit, purchase prices are going to be based on a cautious view of maintainable profits.
Even the prospect of improving the selling price under an earnout deal will be clouded by the economic gloom as no-one seems to expect a swift and dramatic recovery during the next few years.
So what can be done? The obvious answer would be to sit tight and wait for better climes. But that may not suit everyone.
Indeed there may be good strategic reasons why an acquisitive company would like to acquire a complementary business sooner rather than later, if only the owners could be persuaded to sell.
One way forward has been tried before and may be particularly suited to the current conditions.
It is to buy the minimum stake in the target that is compatible with the investor’s objectives, with an option that allows the shareholders to sell, or the acquirer to buy, most or all of the rest when the economy has stabilised and there is a decent track record on which to base a valuation.
That can secure many of the benefits of ownership without over-paying, while retaining the commitment of the vendors who will have the opportunity to enjoy some of the fruits of any economic upside if and when it comes.
This approach was adopted by, among others, Cheil when it bought Beattie McGuinness Bungay and by Cossette (as it was) when it bought Dare Digital, although not necessarily in similar circumstances.
The big players like WPP, Omnicom and Interpublic have adopted a fairly similar approach towards early stage technology businesses and some foreign ventures, buying just a minority at this stage but with first refusal to acquire more later.
Buying companies in stages has rarely found favour in the past by comparison with earnout deals, unless the risks were perceived to be unusually high.
With an earnout deal the acquirer takes ownership of 100% of the business and its profits from the outset, but simply pays for them in instalments that are usually geared to future performance.
But a staged acquisition often restricts the amount of the target’s profits that may be treated as belonging to the acquirer’s shareholders to the proportion of shares it has acquired.
That has a less favourable impact on earning per share and share price of publicly listed companies than would appear under an earnout deal, so it remains less popular.
However, it is now possible to hoodwink the acquiring company’s shareholders into believing that they can enjoy 100% of the profits of a target company even under a staged acquisition.
Provided the acquirer has bought sufficient shares to give it effective control of the target, accounting rules now allow 100% of the target’s profits to be shown as part of the group’s profit for the year. The portion belonging to the vendors is then identified in a footnote.
That new presentation may impress the more naïve of parent company shareholders, but it doesn’t make any difference to the amount of profit that can be paid out to them as shareholders.
In the present climate, it would be wiser to put strategic objectives first irrespective of what the accounting presentation looks like.
If a stage purchase enables some worthwhile deals to be done on terms that will suit both parties, that would seem to be the better choice.
Bob Willott is editor of Marketing Services Financial Intelligence at Fintellect.com
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