Earn-outs are an increasingly prominent component of M&A transactions for sound commercial and operational reasons and can be one tool for bridging valuation differences in the deal-making process.
When used properly, earn-outs can provide anyone looking to sell their business with an additional opportunity post-deal to further increase sale value after the point of purchase, to true-up and validate the headline price.
However, the whole issue around earn-out structures and crucially the likelihood of a seller receiving their full consideration, is something which does not receive enough emphasis, as Fairstone CEO Lee Hartley explains.
The ability of a business to secure the entirety of their earn-out payments is a major differentiator in the sector. Some large acquirers are delivering earn-out payments that result in an average of between 80% and 90% of the original headline price negotiated for those acquisitions.
Crucially this implies that some companies are getting even less than that.
At Fairstone, the firms that we have acquired on average receive 111% of their total earn-out value, with some receiving as much as 139% of their expected consideration. Very importantly, none receive less than 100% of their original sale price.
There are five key reasons why the Fairstone approach to earn-outs is fundamentally different to any other acquirer that is active in the IFA and Wealth Management sector. We have deliberately designed our acquisition model to enable selling shareholders to optimise their future sale value and receive all their capital value in every instance.
Firstly, the conditions placed upon earn-outs with many other acquirers or consolidators are largely outside of the sellers’ control. These conditions can often involve moving assets onto in-house platforms, adopting core fund ranges, guaranteeing inflows into specific portfolios, and increasing client fees.
Earn-out structures should be based on maintaining a sustainable level of financial performance and nothing else, which means that anyone looking to sell their business is in full control of their earn-out. We simply measure revenue and underlying profitability to validate the earn-out, there are no onerous obligations that sit outside of the sellers’ control or which compromise clients in any way. Firms will never be asked to reduce client choice, be forced to shoe-horn clients or funds, or implement any increase to client charging.
Secondly, integration is the foundation of any acquisition and needs to be handled first, whereas many consolidators expect integration to be completed within a relatively short timeframe and conducted after the sale.
Dealing with integration post-transaction can often lead to significant friction, placing undue burden on both parties and critically creating business disruption during the key early phase of an earn-out.
Integration isn’t always easy and involves a lot of change – that is why this process needs to be done gradually over a two to three year period ahead of the sale to help partner firms to grow profits in the intervening period. This means that the earn-out period has no in-built operational resistance and firms can focus on continuing to build their client base and subsequent fee income to optimise sale value.
Thirdly, any acquisition deal structure needs to be specifically designed to enable all sellers to receive full value and share in any upside. Added consideration needs to be given to allowing sufficient runway for firms, which we believe should be typically 36 to 48 months, to continue the growth trajectory that they established during integration, as well as providing a sensible tolerance against the levels of profitability that the initial sale value is based upon. This means that negative fluctuations in new business levels or recurring income do not have a material impact on earn-out payments.
On the flipside, firms should expect to enhance their overall sale valuation if profit growth exceeds this same tolerance after the point of sale. This overperformance can then get factored into the earn-out calculation to further increase the consideration paid.
This approach is highlighted in the outperformance figures we are currently seeing across our entire portfolio of acquired businesses, with partner firms delivering more revenue, profits and growth than either their own forecasts or those upon which the buy-out agreements are made. In very simple terms, we share the upside.
In relation to the entire portfolio of acquisitions that Fairstone have completed no firms have or will receive less than the full value of their expected sale value. The only exception to this would be in the event of a catastrophic failure and disintegration of that business.
This surety over sale value is driven by virtue of the partner firm’s pre-existing levels of sustainable income, the costs that they control, natural growth and the comfort of the ‘safety blanket’ tolerance on performance that is an integral part of our deal structure.
Fourthly, many consolidator propositions are aimed at firms where the principal(s) are looking to retire shortly after the sale, which creates inevitable risk and lack of continuity for staff and clients.
Retaining the human capital is critical in maintaining stability within any IFA or wealth management firm – they are people-based businesses after all. For any sale where the principal is retiring during the earn-out period, there will be a loss of operational control as new people, plans and propositions are put in place, potentially creating confusion and disruption within the client base.
By adopting a ‘sell and stay’ proposition into an acquisition model, you retain all key stakeholders within the business long after the end of the earn-out removing further potential disruption as well as lack of control and continuity for staff and clients. This also creates further opportunities for both companies to build emergent synergies.
And lastly, you need to protect the collective by only acquiring well managed, profitable firms that do not carry a negative regulatory legacy. Importantly, these will be firms who do not contribute adverse risk to the acquirer nor would cross-contaminate any of their other acquisitions.
Establishing a vigorous qualifying criterion and a robust filtering mechanism will ensure an acquirer protects the wider business by only engaging at the outset with firms that they are confident will be a valuable addition.
Handling integration prior to acquisition also enables an acquirer to supplement any initial due-diligence with an extended period of working in partnership which involves building first-hand knowledge of the firm they are looking to acquire.
Crucially this integration-first approach also ensures that both firms are completely aligned in terms of culture, standards and approach to clients before the ultimate acquisition is completed.
It is both sensible and prudent to factor some flexibility into any acquisition proposition to accommodate any instances where the model is not the appropriate fit and where an acquisition would be detrimental to the group as a whole.
This flexibility exists within our contracts and provides the right for a partner firm to exit the arrangements or to delay the acquisition by up to a year to allow for more growth which would positively influence their sale value.
Similarly, Fairstone have the ability not to proceed with an acquisition but only under specified criteria. For instance, if we became aware of significant negative outcomes from our ongoing quality assessment programme or if advice standards or integration obligations had not been met.
The enhanced comfort and confidence that we gain from working closely together during the integration period is one of the principal reasons why we are able to deliver our acquisitions through a Share Purchase Agreement which entails Fairstone taking on liabilities for past advice and migrating all firms from their initial state of PI run-off cover onto our group Professional Indemnity policies.
From the outset we have budgeted for a small percentage of integrations, around 10%, not to proceed through to acquisition. Quite simply we can’t be a perfect fit for everyone, and we would not want to force through any deal that did not result in the right outcomes for clients, our wider business or the Partner firm itself.
Of all of the deals that we have entered into since the inception of the DBO proposition we have not proceeded through to the acquisition on a very small number of occasions and at a rate which sits firmly within our projected attrition. This clearly demonstrates our intent to protect the integrity of our model. No single acquisition is more important than any other and selling principals can take comfort from the fact that we will not complete any acquisition that would present a material threat to the health of the group and any other firm.
A business sale is one of the most exciting—and potentially disruptive—events in the life of a company but the right focus on key success factors and core processes, establishes a foundation for success.
Looking across our entire portfolio of acquisitions we are extremely proud of our proven success in delivering fantastic outcomes for selling shareholders. These outcomes include:
Read more about Fairstone’s approach to earn out structure here.