How do you compare LMM deal prices when seller notes and earnouts are involved?

When comparing LMM deal prices involving seller notes and earnouts, it's crucial to dissect the structure beyond the headline multiple. Here's how these elements are typically evaluated:

1. Cash at Close vs. Total Consideration:

   • Deals are often benchmarked on the cash at close since it represents the immediate, tangible outlay. This is especially important when comparing deals with varying levels of deferred payments.
   • Total consideration (cash + seller note + earnout) is also considered, but it’s essential to adjust for the likelihood of earnout payouts and the terms of the seller note.

2. Earnouts:

   • Earnouts are typically probability-weighted based on the likelihood of achieving the performance metrics tied to the payout.
   • When the seller stays on as an operator, the earnout might be given more credit since they have direct control over achieving the targets. Conversely, if the seller rolls out, the earnout is often discounted heavily due to the reduced influence and potential misalignment of incentives.

3. Seller Notes:

   • Seller notes are treated with caution due to their subordination and variability in terms (interest rates, repayment schedules, etc.).
   • A common rule of thumb is to discount seller notes based on their risk profile. For example, a seller note with low or no interest and a long repayment horizon might be valued at a significant discount compared to one with market-rate terms.
   • The creditworthiness of the seller and the enforceability of the note also play a role in how much weight it carries in the valuation.

4. Rules of Thumb:

   • Cash is king: Deals with higher cash at close are generally preferred, as they reduce risk and reliance on future performance.
   • Earnouts are speculative: Assign a conservative probability to earnouts, especially in cases where the seller exits or the targets are aggressive.
   • Seller notes are situational: Evaluate them based on terms, subordination, and the seller’s financial stability.

5. War Stories:

   • Some buyers have been burned by overly optimistic earnout assumptions, especially when sellers exit and targets are missed due to unforeseen challenges.
   • Others have successfully used seller notes and earnouts to bridge valuation gaps, but only after rigorous diligence on the seller’s ability to meet obligations and the achievability of earnout metrics.

In summary, while headline multiples might suggest a straightforward valuation, the true cost and risk of a deal in the LMM often lie in the details of the structure. A balanced approach that prioritizes cash at close while cautiously weighting deferred components is key to accurate benchmarking and decision-making.

Sources: Overview of Sell-Side M&A, Overview of Sell-Side M&A, Keeping Management Motivated Post-Exit, Is it dumb to exit to LMM PE rather than starting in bigger (MF/UMM) opportunities first?