When we go through the brokerage valuation process, the product is Fair Market Value (FMV).
Interestingly, though, FMV isn’t always the final purchase price in a lot of the deals out there. In mergers and acquisitions (M&A), nearly everything is negotiable, especially the purchase price.
When we see transactions that are executed at a price that is materially different than FMV, it is usually because the deal terms are imbalanced, favoring either the brokerage buyer or the seller.
It is important to understand that in brokerage M&A there is virtually no such thing as an all-cash-at-close deal.
The terms of a transaction almost always include a portion of cash at close, with the remainder in the form of contingent payments over a period of time following the closing, known as an earn-out.
FMV is based on what we consider neutral terms, where the risk is equally shared between the buyer and the seller. Neutral terms are dynamic depending on what’s going on in the market.
Neutral terms a couple years ago, when the M&A market was hot, saw cash at close in the
neighborhood of 40% to 60%, with the rest over a two- to three-year earn-out.
Given the recent housing market travails and ongoing economic uncertainty, neutral terms are currently more in the neighborhood of 25% to 35% cash at close, with the remainder over a three- to five-year earn-out.
Given the prevailing market risk, terms have shifted to favor buyers.
As an example, let’s say a broker had net operating income of $200,000 over the last 12 months. At a 3x multiple, FMV would be $600,000. At this FMV, neutral terms would be somewhere around $180,000 down (30%) and the rest over a four-year earn-out, contingent on the production of the agents who were with the seller as of the closing date.
In very simple terms, if agents produce at the same level over the next four years as they did over the previous 12 months, then the seller would get their full earn-out ($420,000). If they produce less, the seller gets less; if they produce more, the seller gets more (if the earn-out is uncapped), based on a standard earn-out formula.
Using this same example, let’s change the framework to see how terms may affect value, (i.e., the purchase price). Terms that are favorable to the seller provide them with higher cash at close and/or a shorter earn-out than what would be considered neutral.
Let’s say the seller desired 45% at close and only a two-year earn-out. A buyer may agree to these terms, but because the buyer is taking on more relative risk, they would only do so at a lower multiple, say 2.5x. In this case, the purchase price would be $500,000, with cash at close of $225,000 and a total potential earn-out of $275,000.
Terms favorable to the buyer would be lower cash at close and/or a longer earn-out than what would be considered neutral. Let’s say the buyer desired to pay 15% at close and the rest over a five-year earn-out. A seller may agree to these terms, but because the seller is taking on more risk, the seller would only do so at a higher multiple, say 3.5x.
In this case the purchase price would be $700,000, with cash at close of $105,000 and a total potential earn-out of $595,000.
There could, of course, be several other options that may be agreeable to the parties of a transaction, but this is an example of how deal terms can affect value.
Scott Wright is a partner with RTC Consulting in Colorado.