As owners / investors contemplate an exit, there is always the appeal of going “one-more year” before a strategic exit / being acquired. In theory, this makes a lot of sense – a reasonable EBITDA Multiple might add $8-10M in valuation for every $1M in EBITDA growth. Unfortunately, owners often fail to adequately consider the uncertainty introduced by that extra year’s growth, and the valuation risk that results. We hear time and again of businesses that were in a very strong position to exit a year or two ago having missed their window and need to (painfully) reset the valuation expectations.
The risk of an extra year is more subtle than the potential reward and gets overlooked. To illustrate this point – Let’s assume a professional services business generating $5M in EBITDA this year that is contemplating either seeking an exit now or growing EBITDA by another 20% next year before exiting. In this simplified case, assuming an 8 – 10X multiple, the owners / investors are attempting to capture an additional $8M – $10M in valuation with the additional year. The potential reward might seem clear, but when risk-adjusted, it is far from an obvious decision.
Risk #1 A Soft “Next Year”
As confident of their backlog and pipeline as the owners may be, surprises always happen. If a large client leaves, or the revenue pipeline doesn’t convert, a resulting down-year has a catastrophic impact on valuation. The growth trajectory that potential buyers would have found interesting has disappeared, so interest levels and valuation (for a now-plateaued business) follow – manifesting in a lower EBITDA multiple. If this resulted in the loss of 2-3X EBITDA, it equates to $10 – 15M decline in valuation.
Owners could obviously decline this lower offer and continue to operate the business, but that flat year stays in the 3-year lookback. As a result, the owners remain a few years away from being able to command a “growth” premium again, even if strong growth were to quickly return.
Now, if the business had been acquired before the softness, the owners would probably be behind an earnout where a flat year would very likely be within the earnout collar (negotiated by the knowledgeable M&A advisor) – so sellers would still receive a portion of their earnout even in this softer year. Especially noteworthy is that it is far easier to mitigate a soft (stand-alone) year within the construct of a larger acquirer, who by means of a strategic acquisition should be opening client opportunities not otherwise available.
Risk #2 Compounded Growth
Any valuation with a growth premium naturally implies that growth will continue forward – and an earnout is going to mandate as much. Waiting (and growing) another year before being acquired means that the required growth by the end of a 2-year earnout is 3 years out from today. For a high growth business, this compounding quickly adds up. As the table below denotes, a business growing at 20% needs to be 44% larger at earnout period’s end for the full valuation to be realized if the exit is now, as compared to 73% larger if the sellers wait another year.
For a 30% growth business to eke out that additional valuation, the final year of the earnout would need to be more than double (+120%) today’s size, as opposed to 69% larger if they exit a year sooner.
To conceptualize this risk, assume our example business that is growing 20% waits the additional year and successfully increases their valuation by 20%, agreeing to a deal with a 40% earnout (i.e. 20% in Year 2). This 20% is only earned by delivering 73% growth over the base year, which is a very high-risk proposition and if proves too much, produces the exact same attained valuation as would have resulted from an immediate exit. The mechanics of this are that the gain is only ever realized upon continued 20% growth through Year3 – this valuation gain is not captured at deal close.
Risk #3 Market Shifts
With AI just one factor driving massive disruption across every industry, who’s to say something is not going to disintermediate the business. It would only take the risk of disintermediation for prospective buyers to walk away from the category. An irrelevant value proposition with little future value is no longer the small risk that it used to be.
All of this is to say that although the gains of an extra year might appear obvious, they are fraught with hidden downside risks. Like a mirage in the desert, apparently obvious gains of an extra year may only be illusion.
To learn more, you can reach the author, Paul Newton, at paul.newton@bravery.group.
