Valuation Trends / Principles and Working with Earnouts

Deals and even negotiations can’t be done without a proper company valuation. 

Valuation is a fundamental process that helps determine the true worth of a company, providing a solid foundation for negotiations between parties. But valuations are not always objective, and there are a lot of factors that can impact them.  In this article, PJ Patel, Co-CEO & Senior Managing Director at Valuation Research Corporation (VRC), discusses current valuation trends and working with earnouts. 

“During negotiations, the seller would want the earnout to be based on revenue, as it's the most controllable number, while buyers would prefer an EBITDA-based earnout since it's closer to value.” - PJ Patel

Valuation trends

According to PJ, there has never been more uncertainty in the market than there is today. The COVID-19 pandemic has provided a false sense of direction, and the market is currently experiencing a reset, especially in the world of tech. There is a much greater emphasis on quality.

Here are other factors that can greatly affect the company’s valuation:

1. Industry position - If the company for sale is a leader in the industry, valuation can be extremely favorable. 
2. The story behind the company - Storytelling matters. Getting people excited about the company’s vision impacts valuation as long as it aligns with the numbers. 
3. Cashflow and ability to scale - One of the best attributes that attract high valuation is the company’s cash flow, or ability to scale. Even better, if the company has both. 
4. Company maturity - Determining an early-stage company’s valuation is harder because the price range is too wide. The more mature the company, the easier it is to valuate. 
5. Entrepreneur's focus - The more focused the founder is on the company, the more attractive it is to investors. 

Earnouts

Due to the uncertainties of valuations, earnouts are often used to bridge the gap between a buyer's and seller’s expectations. A seller usually wants a high price for their company while a buyer is more conservative when during valuation. Earnouts are contingent payments based on the performance of the acquired company after the deal.

While most buyers do live up to their promise of paying the earnout, misalignments can arise post-acquisition, leading to disputes and even litigation. To avoid such scenarios, both parties need to maintain open communication and ensure their interests remain aligned.

Negotiating Earnouts

When negotiating an earnout, buyers usually want something long-term and based on EBITDA thresholds, while sellers want something based on revenue, and over the shortest time possible. Like any other negotiation, the party with more leverage will dictate the terms and conditions. PJ suggests that sellers must introduce competition in the process to gain leverage and a better understanding of their market value.  

If earnouts are not suitable for the deal, there are other ways to bridge the valuation gap, such as rollover equity. 

Rollover equity is when the seller gains a stake in the new combined company. This is a great way to retain the people in the acquired company and keep them motivated, while giving additional compensation beyond the cash upfront in the deal.

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