Earnouts in cannabis M&A: Sharing the risk and reward

Earnouts are a common risk-allocation provision in cannabis and hemp mergers and acquisitions, and earnouts are used just as they are in other business sectors to bridge the business-value gap between a business owner and an acquirer, when the owner wants more money than the acquirer initially wants to pay.

Essentially, an earnout allows part of the purchase price to be paid out when certain pre-agreed performance metrics of the acquired business are achieved over a specific period of time, often one to two years, instead of at the transaction’s close.

The reason earnouts are used is simple: Sellers want the highest possible valuation, and buyers, who may be willing to pay top dollar, want to make sure the company lives up to performance promises, usually based on one of these categories: gross revenue, sales revenue, net profit or EBITDA.

When valuing a business, most buyers use data from the last fiscal year (or trailing twelve months), while also examining financial statements that reach back three years or more.

But what if the seller is well into the financial year at the time of sale, and the company is putting up great numbers, with strong growth projected for the rest of the year?

The seller rightfully wants to get rewarded for that performance, which may not be reflected in the last fiscal year’s financial reports, or – for solid near-term projections – even in the trailing twelve months, particularly in an industry like ours that may not have a lot of historical data to build on.

If the seller requests it and the buyer is open to it, the buyer could peg the company’s value to the trailing twelve months (TTM) performance, which represents the last twelve months of results prior to the closing, while offering rewards for the achievement of projected growth, if it is achieved.

OK, let’s look at an example.

Say an owner wants to sell his or her business in the middle of the fiscal year. But, with sales on an upswing, the owner wants a valuation credit for the forecasted remainder of the budgeted year. Let’s assume this business did $2 million in EBITDA the previous year and is projected to do $2.3 million in EBITDA in the current year.

Based on a 7X multiple of EBITDA for both periods, the valuation for the previous year’s performance would be 7X $2 million, or $14 million.

Apply the same multiple to the current year (partially booked/partially forecast), the 7X would raise the valuation to $16.1 million – a nice lift of $2.1 million in value.

In this scenario, it would be realistic for the buyer to offer the valuation of $14 million, based on the previous year’s results.

But the seller doesn’t want to leave any money on the table, since the company is having such a good current year. He or she wants the 7X multiple to be applied to the $2.3 million number, not the $2 million number.

The buyer and seller may agree to a $2.1 million earnout in addition to the $14 million. The earnout would not be paid unless the seller achieves $2.3 million in EBITDA for the current year.

When structuring the performance metrics for an earnout, it will behoove the seller to seek advice from an experienced investment banker. If you are a seller, you want to base the earnout using realistic financial performance goals that can be achieved.

The seller should also insist on operational control of the business (and budgets) so they are not restricted in their ability to achieve the earnout goals.

What metrics are best to use when establishing targets?

A buyer is typically interested in one financial target: the bottom line, either net income or EBITDA. But other performance goals may be baked into the rules of what must be achieved to get the earnout, such as gross profit margin and EBITDA margin.

No matter what metrics are chosen to peg to the earnout, what’s really important is that the terms are fully and easily understood and perceived by both sides as fair.

Let’s look at both the seller and the buyer’s perspective: The seller needs to be clear about what the buyer will control, post-close.

At a minimum, the seller will want to protect the resources necessary to achieve his or her earnout targets.

But if the buyer is going to tack on additional costs to the seller’s business, such as expenses for selling, general and administrative (SG&A) expenses, or vacate marketing budgets needed to drive new business, then the seller should probably avoid pegging the earnout to EBITDA. Instead consider tying the earnout to sales or gross profit dollars.

In any event, a clear understanding of the terms and metrics is essential to keep both sides happy, cooperative and working together toward their mutual success.

A final note:

When the market rate for cannabis and hemp companies is 7X for all-cash-at-close transactions, we will sometimes be approached by sellers who say: “I’ve got another firm that says they can get me 12X.”

We often respond: “Well, you should go with them because we think that is unrealistic in today’s market.”

What has likely happened is that seller has confused the multiple that can be obtained in an all-cash-at-close deal with the higher multiple that might be calculated after a multiyear deal is all paid out through earnouts.

If the seller wants to share risk with the acquirer and stretch his or her earnout payments out for multiple years, then a higher multiple often can be obtained.

More risk, more potential reward. But there’s nothing like the security of an all-cash-at-close transaction.

 John D. Wagner and Dr. Carl Craig are managing directors of Colorado-headquartered 1stWest Mergers & Acquisitions, which offers a specialty practice in the marijuana and hemp sectors. 1stWest M&A has transacted more than $1 billion in deal values.