Valuing franchise companies for the purpose of sale in times of uncertainty: Use of earn-out provisions

The business dynamics calling for earn-outs

Buyers and sellers of franchise companies in the COVID‑19 pandemic era face potentially daunting valuation challenges at a time when selling may be critical for survival and/or buying may be strategically warranted.  Government-imposed quarantine and other safety and health requirements have had a significant adverse effect on businesses in many sectors, in many cases reducing the primary bases for measuring valuation, namely revenues and EBITDA.  If the expectations are that those reduced performance metrics reflect the “new normal,” then that is one thing; but, on the other hand, there are certainly hopeful signs that, with the economy reopening (sporadically perhaps), business performance and the financial metrics that form the basis of measuring valuations will likely recover.  Yet recovery may involve changes to the business model and potential profitability as a result of the impact of COVID-19 pandemic restrictions.

For example, a dynamic shift may be taking place in customer perception and the market for the  products and services; buying patterns may be changing (eg, takeout versus sit-in dining, e-commerce versus bricks and mortar stores) and impacting revenues; cost structures of operating units may be affected, such as COVID-19 testing and protective equipment for employees, additional employee training and in-store social distancing requirements.  The full impact of all these changes may not be known for some time.  In other words, new market conditions are emerging that may impact the franchise business model.  At the time of a potential sale transaction, a seller may be in the midst of these adjustments.  So, how do you value a company that certainly has foundational value but is in flux?  To consummate a sale of a company in such an environment requires creative thinking, and one approach worth considering in this context is the earn-out.

What is an earn-out?

Earn-outs focus on future financial milestones for company performance which, if met, will yield additional payments from buyer to seller. 

Let’s illustrate the concept by example.  Assume the target franchise company had 12-month EBITDA as of December 2019 of $100 and a reasonable purchase price would equal 5 times EBITDA, or $500.  Now assume that, by the end of July 2020, that same business, as a result of COVID‑19, had 12-trailing month EBITDA of $60, resulting in a valuation of $300.  A buyer considering buying the company may be interested in proceeding based on a price that is no more than the trailing 12-month valuation (ie, $300) due to the uncertainty of what the “new normal” will look like.  At the same time, a seller may be highly motivated, but adamant that the trailing 12-month EBITDA valuation is not representative of the value of the business as the company is in the midst of a possible (likely?) recovery.

So how do you bridge that gap in perception?  The earn-out clause may address it.  In this example, the earn-out clause may provide that the seller will receive $300 at closing and, if business performance improves within, say, 24 months, additional consideration will be paid.  So, if the business returns to EBITDA of $80 at the end of 12 months, the buyer would pay an additional $100 to seller and, if the business reaches its prior EBITDA of $100 by the end of the 24-month period, an additional $100 will be paid by buyer.  In this respect, a sale transaction can be consummated now, with a sharing of risk, based on the future recovery of the business.

The complexities of earn-outs

The concept as articulated is straightforward.  It appeals to both parties’ interests:  the seller’s desire not to sell short, and the buyer’s interest not to pay more than fair value.  The complexity lies in the details, which include both legal responsibilities and operational requirements during the earn-out period, both of which must be clearly articulated in the legal agreements.  Knowledge of both the legal structuring and operational metrics is essential for the earn-out to work properly.

The complexities involved in structuring earn-out clauses basically derive from the “what ifs” that follow the initial concept.  Among the key issues:

1. If restoring the business to its prior – or, perhaps more likely, its new – level of success depends on consistency in operations, will the buyer continue to operate the business in the direction and manner of the seller?
   
   
2. Will the same accounting methodologies apply post-purchase?Does the buyer allocate overhead allowances to its individual businesses which might reduce EBITDA?  What is the anticipated level of capital investment necessary to achieve the “new normal,” and will the buyer commit to make such investment?
   
   
3. Let’s assume, as described above, that the earn-out clause provides for two additional payments of $100 each if the EBITDA recovers to $80 in 12 months and $100 in 24 months.  If EBITDA at 12 months is $75, is the entire first payment forfeited (ie, all or nothing)?  Is there a pro rata payment?  Should performance be averaged over the two measurement periods, or is a “catch-up” permitted (eg, if EBITDA at the end of 24 months is $105, so that the shortfall from the first period has been recovered, should the unpaid part of the first payment be paid in the second period)?
   
   
4. What if the buyer sells the business prior to the end of the earn-out period?  Must the second buyer assume the earn-out?  Must the first buyer pay it in full at closing of the second sale?
   
   
5. What is the standard for advertising and promotion of the business and regenerating revenue?  If the performance measurement is revenue and not EBITDA, the seller would want significant promotion, as the expense may generate revenue while reducing EBITDA.
   
   
6. What will be the timing on restoring staffing levels if furloughs occurred during the prior months, and how will that schedule impact the performance metrics?
   
   
7. Will there be required refurbishment expenses during the earn-out period, and how will they impact operations and EBITDA (ie, closings for renovations reduce revenue and EBITDA)?
   
   
8. What rights will there be for the seller to audit performance and dispute results during the earn-out period?

Moving forward with earn-outs

As buyer and seller – and their legal counsel – reflect on the “what ifs” that may impact performance during the earn-out period, the contract obligations can be structured and drafted.  To avoid potential disputes, the parties are encouraged to create clarity in the contract obligations.  In structuring the earn-out terms,  is recommended that there be essential elements of underlying trust, transparency and accountability between buyer and seller.  The seller relinquishes control of the assets/entity but is still dependent on their future performance for realizing the additional consideration and, while buyer and seller remain interdependent and mutually interested in the success of operations during the period, the buyer has long-term motivations which focus beyond the earn-out period. 

A properly structured and drafted earn-out provision can strike a balancing of interests between buyer and seller, resolve the “what if” issues and create the necessary transparency and accountability. Recognizing the complexity, the parties can craft the contractual structures and obligations which overcome the uncertainty of determining value in difficult times.

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This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.