Re-participation and earn-out mechanisms in small-cap M&A deals in DACH region 2023
When we at Winterberg Group acquire Mittelstand companies in the DACH region, we encourage the selling shareholders to re-participate with a minority stake in the company. Why? The answer is simple – on the one hand, we want to share a portion of our risks. On the other hand, for owners, it’s usually a good way to invest part of the proceeds from a sale and continue to build up their wealth.
From our experience, ways of re-participation may vary on a case-by-case basis, but are generally one or another form of the following three mechanics:
Re-investment: The business owner can re-invest some or all of the proceeds from the sale of the company into the acquiring company (AcquiCo or the Fund). This can be done through investing cash proceeds from a sale in a new fund that will hold the acquiring company.
Equity rollover: In an equity rollover or in-kind contribution to the Fund, the business owner exchanges their ownership in the acquired company for ownership in the acquiring company. This allows the owner to maintain their stake in the business and benefit from future growth.
Earn-out: An earn-out is a contractual arrangement where a portion of the purchase price is contingent on the future performance of the acquired company. One way of looking at this, is that a part of a purchase price is simply deferred, while others may consider it as an investment mechanism. Ultimately, the seller receives less cash at closing with an opportunity to receive more if the business performs well. Technically it is equal to re-investing cash or company shares in the Fund.
In certain cases, we offer a combination of the above options which helps us and the selling shareholders to achieve a mutually beneficial result. Not all deals are created equal, so it’s important for us that the business owners carefully consider the re-participation mechanism that they’ve been offered.
Typical Seller’s perspective on re-participation and earn-outs
Typically, the seller will be open to a reasonable re-participation and/or an earn-out, provided that key aspects are well and transparently documented in the SPA. However, the most frequent questions are the following:
Q: Are the milestone targets reasonably achievable in a reasonable time period?
A: We usually base our KPIs based on the Seller’s business plan and/or historical performance of the business. Therefore, the Sellers are definitely capable of evaluating the possibility of a business plan achievement.
Q: How can the seller make sure the buyer doesn’t operate the business in a way that minimise or eliminates the earnout payments?
A: It has never been and never will be our intent to undermine business performance in any possible way. That’s not wise to shoot your own business in the leg, as the business needs to have a compelling story for the next buyer. If the concern is strong, we usually provide a performance metric range, so that the seller receives a portion of the deferred payment even in cases when the company performs worse than planned. In addition to that, re-participating sellers usually have customary board representation rights and are participating in the operations, so they have enough leverage to see the true performance.
Q: Is the amount of the potential deferred payments significant enough to delay the seller getting all cash up front?
A: All deals are different, and all sellers have different circumstances and plans. In deals we typically do, the earn-out and re-participation components are within a range of 10 to 30% of the purchase price.
Why is it important for us that the selling shareholders re-participate?
Overall, the re-participation of selling shareholders is usually beneficial to both us and the selling shareholders, as it helps to drive growth and profitability for the company.
First off, re-participation aligns interests: When selling shareholders re-participate in the company, they have a stake in the ongoing success of the business. This aligns their interests with those of the financial investor and management team.
Secondly, and this is critical for Mittelstand, expertise and experience: The selling shareholders, who are usually owning the business for generations, often have significant expertise and experience in the industry and with the company. This is valuable to the financial investor and management team as they work to grow the business.
Another reason is confidence in the business: If the selling shareholders are willing to re-participate in the company, it is a positive signal to us that they have confidence in the business and its future prospects.
How does the common market practice look in 2023?
In terms of the DACH market, some agencies regularly solicit feedback from a wide number of M&A advisory firms on their market outlook. One of the recent reports by Firmex, for example, suggests that M&A advisors reported that deal volume remains constant with half of the respondents forecasting deal volume in the coming three months to increase. At the same time, over half of the M&A firms questioned observed a growing gap between prices asked by sellers and prices buyers are willing to pay. The gap in value expectation is being increasingly filled by special mechanisms to narrow the gap in price expectations, like re-investment and earn-out mechanisms. Four out of ten M&A advisors said that earn-outs have become much more common. That certainly resonates with our own experience here and we see this as a necessary instrument in times of uncertainty which we definitely have today.