Key considerations when designing incentive schemes to support exit success

By Penny de Valk, Associate Director, Equiteq.

Knowledge-intensive services firms can achieve faster growth and reduce founder dependency through diversifying management roles, smart succession planning and equity incentive schemes. These steps support higher future exit values, better deal structures and increase the likelihood of achieving earn out targets if key people are retained and share in the earn out.

From the founder’s point of view, introducing equity incentives will probably be one of the largest investments the company makes so it’s really important to get this right.

Too often tax planning takes crowds out the more important process of designing a commercially effective scheme. Tax is important, but an approach that ensures the growth and exit vision is aligned by evaluating how much value to share, with who and over what time period should come first.

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The hidden value in your management team

management-team

There is no doubt that leadership and management in any organization is critical to building business value, but did you know that it’s also a focus of most consultancy buyers’ due diligence when considering a purchase?

On a recent webinar, Equiteq Chairman Paul Collins answered questions on why management quality is important to consultancy buyers and investors.

  1. How do you manage the potential conflict of building the profiles and skills of managers to attract a buyer when these managers may want to leave after a sale?

The focus of buyers during due diligence is on the top two levels of leadership in the business – the board leadership and the business unit leadership. Managers at this level are often required to stay with the new firm for a period after sale.

If your managers are intrinsically involved in every significant operational activity, then a buyer would be reluctant to see them exit. But if a manager’s responsibility is easily transferable, then there is a greater chance of a buyer allowing a manager to move on.

If you’re a business owner who wants to exit immediately after selling, rather than staying in the business during an earn-out period, you need to make yourself superfluous to the day-to-day running of the business before entering into the sale process.

Not sure about what an earn-out is? Here’s our blog on the 10 critical success factors for earn-outs: part 1.

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The lessons I learned when selling my consultancy

Marc Jantzen is the former Chief Executive of performance improvement and training consultancy Blue Sky. We recently held a webinar where he shared the lessons he learned from selling his business to Capita and answered attendees’ questions on what it was like.

  1. How do you know if your business is ready to be sold? Do you sell when there is no growth / when you’ve reached saturation?

While the reasons for selling are always personal, it is unlikely that you’d find a suitable buyer if the business appears to be stagnating. Buyers are purchasing the future potential of a business to grow and generate profits.

So, if your consultancy isn’t growing, it is important to identify the cause and perhaps bring in advisors, like Equiteq, to help your business develop a growth plan that gets you in shape and ready for sale.

Click here to read a post from Paul Collins, Chairman of the Board of Directors at Equiteq, on the right time to sell.

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What I learned during the sale of my consultancy

Deal Cropped

This week we have a blog from Marc Jantzen, founder and former CEO of Blue Sky Performance Improvement, who sold his consultancy to Capita in 2013. He is now an Associate Director at Equiteq.

We’d been building value in our consultancy with a view to selling it for several years and I was pleasantly surprised at the speed with which we received an offer, and at its size, when we decided the time was right to sell. However this was by no means the only surprise in a sale process during which I learned a lot.

Balancing everyday operations and deal demands

While there will obviously be more work to do during the deal process, the challenge of running the business in parallel with meeting information requests for the deal should not be underestimated. Bear in mind too that if you choose not to share the fact you’re looking to sell widely with staff, you will find yourself requesting information from staff and not being able to explain exactly why you need this data.

And the demands do not fall only on the management team; the finance team’s workload also increases dramatically. If I was going through the process again now, I would hire additional resource for our finance team, because we found that they didn’t have time to keep on top of our debtors like they normally did. This affected our working capital, which is a key figure that buyers scrutinize.

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10 critical success factors for earn-outs: Part 2

The process of growth of income

In one of our recent blog posts we outlined why earn-outs are commonly used by buyers and looked at the first 5 considerations  to take into account when thinking about an earn-out. This week, in part 2, we look at the final 5 aspects to reflect on when it comes to earn-outs.

6. Set a realistic time period

The effluxion of time means that an earn-out is at risk from the vagaries of market conditions, customer losses, technological advancement and increased competition, to name just a few factors. A 2 or 3 year period is typical – obviously the shorter the better for a vendor. Our research highlighted that while the average length of earn-out was just less than 3 years, prolific buyers (those who bought more than 2 businesses per year) were more likely to prefer a shorter earn-out period. Knowledge of buyers’ behavior is invaluable in these negotiations.

7. Limit the basis of an earn-out to aspects of the business you can control post deal

For example, if your business is heavily reliant on marketing spend to achieve sales growth and post transaction you have no control of the marketing budget, then immediately you are putting the achievement of your earn-out at increased and unnecessary risk. A full assessment of the transaction situation pre and post deal will highlight any areas of concern.

8. Corporate overheads

Be aware of any ‘costs’ which might be added to your P&L by a buyer post transaction and which could limit your chance to achieve your targets. Knowing how a buyer will behave post transaction and getting these issues on the table for discussion early is a key role for any advisor.

9. Tax treatment

With any performance-based payment there is a risk that the tax authority in your jurisdiction will look to treat it as income rather than capital with the attendant increase in tax that comes with it. Get good tax advice early.

10. How should it be structured?

All or nothing earn-outs don’t tend to work, so typically a sliding scale with caps and collars to penalize underperformance and reward over performance are the norm. A thorough understanding of whether the buyer’s aims are purely financial or whether they are mostly strategic has an impact here.

Will it be possible to catch-up payments later? How is performance to be measured – quarterly, annually, on average?

There is considerable scope for an earn-out to go wrong which is why it’s important to get external advice on how to best structure them. Understanding the motivations of a buyer and then formulating a structure which meets those expectations, whilst protecting you as a vendor, is the ideal scenario. A buyer will want an earn-out to be achievable and so will take guidance from the vendor and their advisor about how best to structure it as a win-win.

To read the full article this blog is based on please click here.

Are you a member of Equiteq Edge? It’s full of content to help consulting firm owners prepare for sale and sell their business. Register here to gain full access.

10 critical success factors for earn-outs: Part 1

Earn-outs Cropped

If you’re planning on selling your consulting firm, it’s highly likely that the transaction structure will contain an earn-out. In fact, 90% of deals involving consulting businesses will have a structure which includes some sort of deferred payment, with most taking the form of an earn-out. Your objectives would normally be to maximize the up-front cash percentage and alleviate the earn-out terms. Therefore it is worth being aware of the complexities associated with earn-outs and having access to the knowledge which will allow you to structure it in the most sensible and beneficial way. Our Buyers Research has a chapter on earn-outs and you can access the report here.

Earn-outs can be used by a buyer for any number of reasons but some of the most common are:

  • To obtain commitment from the vendors post transaction
  • To introduce specific targets which are non-financial to ensure a smooth transition post deal
  • To mitigate a valuation based on the delivery of a high growth forecast
  • To lower the day one funding requirement; and
  • To bridge a gap in price expectations between vendor and buyer by allowing a higher headline value

Earn-outs are not one-size-fits-all and must be tailored for specific circumstances. However there are 10 over-arching considerations that should be taken into account. We’ll be looking at the first 5 in this week’s blog, with the final 5 to follow next week.

1. What should the earn-out target be?

Set it too high and it becomes a disincentive, too low and it won’t be incentive enough. The target should be achievable for the vendor and provide a mechanism which ensures good value, driving the right behaviors for the buyer.

It is difficult to provide qualitative advice on what a target should be as clearly every situation will be different; however you should consider the following:

  • Base the earn-out on your existing organic business plan as you should be able to deliver this as a standalone entity, and it should only be enhanced by the buyer’s infrastructure and client base – assuming minimal interference in the way you run the business
  • Whilst it is usual for a buyer to want to have a cap on the earn-out, it doesn’t normally make commercial sense for either party as the additional consideration from exceeding an earn-out is usually self-funding. Get a thorough understanding of what the combined business opportunity is, and use this to assess the risk of hitting earn-out targets
  • Conversely, ensuring you include adequate downside protection within the earn-out is also key. This should ensure you still receive some value from it, even in the case of missing the target. However, for obvious reasons, this is a much more sensitive discussion
  • Avoid linking large proportions of the earn-out to specific targets with binary outcomes

2. Avoid complex, many-variable structures

Complexity of earn-out structure makes it very difficult to negotiate and document legally during the transaction, and also difficult to measure post transaction. The result is excess negotiation during the process and subsequent arguments post deal.

Trying to make an earn-out achieve many different outcomes is fraught with difficulty. At its most simple an earn-out should drive behavior which creates value and growth for the acquirer.

3. What happens if you leave?

Ensure you know what happens to the earn-out payments if you have to leave part way through, either through your own choice or a forced exit. There are many ways to ensure that you are protected in this case.

4. Consider the implications to the integration process

Earn-outs can sometimes be a hindrance to integration of the vendor’s business into the buyer as typically the vendor’s business needs to be ring-fenced from a reporting and operating standpoint in order for the earn-out to be measured. This can destroy value for the buyer and also completely undermine the original rationale for undertaking the acquisition in the first place.

5. Earn-out payments rely on the financial viability of the buyer

Being satisfied that the buyer will still be solvent at the end of the earn-out period, or including protections in the sales documentation, is key.

Check back in next week for the second 5 critical factors for earn-outs. Or if you can’t wait, please view the full article this blog is based on here.

Are you a member of Equiteq Edge? It’s full of content to help consulting firm owners prepare for sale and sell their business. Register here to gain full access.