[Updated Nov ’24 – first published on LinkedIn in Nov ’23]
Have you ever wondered what factors guide the world of agency M&A?
The game is intricate, and the rules are not always clear.
Owners, armed with tales of past deals and advice from peers often enter the arena with a preconceived notion (as we did once too): The buyer sweeps in, buys a majority stake based on a profit multiple, and the founders’ fate is sealed in an earn-out agreement.
In Agency M&A ‘lore’ earn-outs generally get a bad rap but are they really that bad? What should you consider when assessing an earn-out and what are the alternatives?
We’ll come to that, but first according to some, earn-outs can lead to some undesirable behaviours such as…
=> Buyers setting unachievable targets and then using their power as majority owners to strip resources, making targets doubly hard to achieve
=> Buyers levying large management fees and back-office charges that stymie the earn-out
=> Owners becoming so obsessed with their targets that it leads to undesirable management behaviours and at worst an internal cultural melt-down
=> Founders fiercely defending resources within their fiefdom in order to preserve earnout and therefore limiting the accretive value of the acquisition.
Savvy buyers and sellers are now much more focused on cultural alignment and staff retention. It’s something we call Empathetic M&A. The key insight here is that most failed transactions can be traced back to a lack of cultural fit.
Of course, having said all of that, there is a positive side to earn-outs and it is two-sided: they reduce risk for the buyer and can create strong upside for the founders.
If you are considering M&A then you can be sure that earn-outs will be on the table—and knowing your stance is crucial. If you want to avoid an earn-out at all costs it is possible, but your business must be a cashflow machine that simply does not need you in it at all (a medium-sized accounting firm anyone?)
In reality, few agencies work this way – if you’re one of them good for you!
Here are some of the typical deal structures and frameworks tailored to address the unique characteristics of agencies, (i.e. a reliance on great people, client relationships, and intellectual property).
Recapping Earn-Outs
An earn-out is a mechanism where the seller receives future financial compensation based on the agency’s post-acquisition performance. This aligns the interests of both parties, ensuring the continued commitment of the selling agency’s management and staff.
The earn-out can be based on various metrics, such as revenue, profit, or client retention over a specified period. Care must be taken in agreeing on what you align to as almost all KPIs have their pros and cons.
Upfront Payment with Deferred Consideration
A portion of the agreed purchase price is paid upfront, while the rest is deferred and paid out over time, contingent on certain conditions or milestones. This is very similar to an earn-out but under this structure, the buyer would vest most or all of the equity immediately.
Critics of this structure will say that the seller is effectively financing the buyer into the deal by allowing their future profit stream to be used to pay down the debt.
However, any variations in value are typically recognised in the form of a retrospective ‘true-up’ (also generally true in earn-outs). So, this can work positively for sellers, especially in a union where the buyer is committed to assisting the agency to scale up. It can mean that the effective profit multiple over the deal is much higher.
What’s more the deferred payments can be aligned to very soft factors such as ‘you’re still in the business’ and they have the added benefit of encouraging integration (rather than fiefdom building).
Vendor Finance & Seller Equity Participation
Deferred consideration and earn-outs basically act as vendor finance, where sellers back buyers to mitigate risk and sync ambitions, allowing them to use future profits to pay down the debt. The important question is usually how much risk sellers want to take off the table immediately, vs risk for some future upside.
Seller Equity Participation means that the seller retains a chunk of equity in their firm (usually a minority holding). This can align the seller’s incentives with the buyer’s and demonstrate confidence in the agency’s future prospects.
Rolling Equity
To build on the above, the owners of the selling agency might “roll” a portion of proceeds into the equity of the acquiring firm, the new combined entity or the acquiring fund. This allows them to participate in the future upside of the business and de-risks the deal for the buyer. This is a common PE approach. Theoretically, in the PE world, this might allow a successful founder CEO to roll equity several times as the group grows and is sold on, taking some equity off the table each time.
Stock-for-Stock Transactions
Instead of cash, the seller receives shares of the acquiring company. This is more common when two agencies merge, or when the acquiring entity wants the selling agency’s owners to have a stake in the future growth of the combined entity.
Floors and ceilings
In the context of earn-out or deferred payment the “floor” represents the minimum performance threshold that must be achieved before any earnout payments are triggered.
Conversely, the earn-out “ceiling” represents the maximum amount that can be earned through the earn-out arrangement.
These can be quite critical aspects of deal structure that significantly affect the risk and reward profile of the deal for both parties. They also explain in part why a deal is typically so much more than simply a multiple of profit.
Performance-based Incentives
To build further on earn-outs and deferred considerations there can be additional incentives based on specific performance metrics, like expanding into new markets, launching new services, or achieving high growth rates. Sometimes these may attract a ‘kicker’ to the multiple. Each extra multiple is known as a ‘turn’ in the industry.
LTM vs Averages
LTM refers to ‘last 12 months’, and this is sometimes used in deal structures where there has been rapid growth over a few years, or where the effects of a variable from a prior year need to be removed. More often than not an average of the last 3 years’ profit may be used to even out risk. Occasionally the forecast is used too. This averaging approach may also be used in an earn-out period, again to reduce risk on either side. E.g. the average EBITDA over a 3-year earn-out vs. the 3rd years EBITDA is used to agree the final Enterprise Value (EV).
Management Retention Packages
Given the importance of key people in agencies, retention packages are sometimes structured to keep key personnel onboard post-acquisition. This can include bonuses, stock options, or other financial incentives. Stock options can be tricky to navigate and our view is that buyers prefer the simplicity of long-term and short-term incentive plans (LTIPs and STIPs). See an interesting perspective from John Warrilow here.
Client Retention Bonuses
Similar to management retention, bonuses or incentives can be structured around the retention of key clients, post-acquisition.
‘Founder-friendly’ deal structures
Occasionally we come across a structure that is purposefully designed to address some of the issues mentioned above. One such arrangement we have seen recently from a growing network is to acquire parcels of equity from founders in 10% increments up to 51% (sometimes referred to as creeping equity). Where this model differs is that it’s on a revenue-based valuation, not EBITDA.
This means that owners with growth ambitions can realise a substantial amount of value over the first few years, riding the revenue curve upwards. Then they can look forward to a second ‘bite of the apple’ in a much larger group transaction based on an EBITDA multiple (as we have mentioned before scale is key to agency value (see point 11).
Well, that’s the theory at least. As with all models it pays to understand exactly what you’re signing up for so do your homework.
Asset vs. Stock Purchase
In an asset purchase, the buyer acquires specific assets (like client contracts, and equipment) and certain liabilities, but not the legal entity itself. This can be beneficial for the buyer as it can exclude many liabilities (aka skeletons in the closet!) It can also leave the seller free to wind down their business in the most tax-efficient way (e.g. drawing out retained earnings in successive tax years).
In a stock purchase, the buyer acquires all or part of the entire company, including all of the associated assets and liabilities. [In this case, the Sale and Purchase agreement will contain warranties amd indemnities designed to reduce buyer risk].
Both types of deal are common.
There is a scenario where a new entity may be created into which to transfer either the assets or equity of the seller or from which to conduct the purchase. This is where you may come across the phrase ‘reverse’, or ‘forward triangular merger’. It’s simply referring to a third entity that is involved in the deal structure. As always, make sure you’re getting good advice around your deal structure, and for this, you need tax, legal and M&A advisory.
Non-compete Agreements
Given the relationship-driven nature of the agency business, non-compete clauses are common. These prevent the selling agency’s owners or key personnel from starting a competing business or poaching clients for a specified duration.
A last word about Tax
In the event of a transaction, you will want your deal structure to be tax-efficient for shareholders. This is something that you should think about prior to any M&A activity. Too often the process of M&A is started, only to discover the firm is not structured appropriately and in the worst cases, deals fall over because there is a large tax burden that the shareholders were unaware of.
So important this one!
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OK, so this was a long, (yet by no means exhaustive) post!
The key takeaway is that deal structures for agencies tend to be future-focused and combine many of the concepts above.
In the end, the structure will be shaped via an alignment of the goals and concerns of both the buyer and the seller. No alignment, no deal!
Proper due diligence, negotiation, legal and tax expertise are crucial in crafting a deal that benefits both parties.