By Steve Abbate
A large part of our business involves representing owners who are selling their home energy company. We have received well over 100 offers for businesses in the last year alone. Of those offers, around 80% contained some type of future performance payout or “earn out.” In contrast, over 70% of the offers that our clients have accepted were for cash (or almost all cash) at closing. Better understanding how an earn out works helps both buyers and sellers evaluate offers to determine what they will actually pay or receive from the transaction.
There are several types of earn outs based on various future performances. We have worked with retained EBITDA, retained gross profit and retained gallons. The most prevalent earn out in the heating oil industry is the retained gallon earn out. As a note, it is important to understand that companies are not valued on a cents-per-gallon basis. Companies are valued on return on investment for the buyer. Items like service income, cap fees, energy audit income (and other diversification income), operating expenses and future capital expenditures are all used to calculate value. After the company is valued, the buyer may pay the seller on a cents-per-gallon basis as one of many ways to measure future performance. Gallons are an easy method so many people like to use gallons. I like gross profit earn outs, but they are rarely used. These methods also allows for the purchase price to be paid out of the earnings of the business. Paying from earnings is a great technique for a buyer who has limited cash.
In a retained gallon sale, the seller will not know how much they sold the business for until he or she receives the last payment. In addition, the seller usually takes a subordinated position behind the buyer’s bank, and typically will not be paid if the buyer has serious financial difficulties. Knowing the financial condition of the buyer is important. You should also know how they will run the business after the transaction. There have been many accounts of buyers who raise margins after a sale and lose a substantial amount of gallons, thus reducing the final purchase price. That is one reason I prefer the retained gross profit structure as a second choice behind a cash transaction.
Even if you sell your business to a buyer who does a good job at keeping the customer, you will still lose gallons to attrition, conservation and conversion. A typical fuel company loses 5%-7% of their customers annually, just from homes that are sold. If you are selling your company, make sure you add language that says you will be paid for not just the gallons that are delivered to the customer but also the gallons delivered to the customer address. This is difficult to track but it gives you an extra safety net against lost business.
Keeping the retained time period relatively short will also improve the total compensation you will receive for your business. The chart below is based on a company selling 1,000,000 gallons (weather adjusted) of heating oil and a retained gallon offer of 90 cents. The quick math is that this should equal $900,000; however, with just normal attrition (6%), conservation (2%) and conversions to other fuels (1%) a five year retained gallon transaction will only yield the owner $684,000. The chart shows the projected result for payouts ranging from 1-5 years. We find 3-5 years are the most common offers made.
Receiving a portion of the selling price in cash at closing, negotiating a floor price or taking a promissory note are some ways a seller can reduce the risk associated with earn outs. You can see from the math why so many of our clients prefer a cash transaction, even at a discount.
With that said, a cash offer is not always on the table or the cash offer may be substantially below the projected net payout. There may also be tax reasons for carrying out the payments over a period of years. With any transaction it is always important to consult your tax advisor. It’s not always how much you sell it for, it’s how much you get to keep.
Steve Abbate is the president of Cetane Associates, which provides hands-on merger and acquisition advisory services for privately held companies. Abbate has been providing M&A advisory services for most of his career. In addition to his track record of completing over 70 successful transactions, he has consulted with and performed financial and opera- tional evaluations on hundreds of businesses throughout the U.S. Office phone: 410-480-4930; cell: 410-404-3199; www.cetane.net.