Valuation challenges in agriculture M&A
As in every sector, agriculture company owners and investors often disagree on valuation when negotiating the terms of a potential sale. This is especially true when a valuation depends on a company’s future cash flows, which can be hard to predict due to the inherent volatility of agriculture commodity prices. Uncertainty can increase further because of production cycles, company-specific risks, and sector-specific challenges such as unpredictable weather.
Using earnouts to bridge valuation gaps
To overcome deal-breaking impasses caused by valuation disagreements, one common solution is an earnout. Private equity investors often use earnouts in M&A deals when predicting a business’s future cash flows is difficult or when the company’s post-sale performance heavily depends on the seller’s continued commitment. This tool has become especially important in cross-border agriculture M&A. This is due to investors lacking sector-specific expertise or the ability to manage a company in a new agriculture vertical.
How earnouts work
In simple terms, an earnout defers a portion of the purchase price until pre-agreed financial or operational targets are met. These targets can be based on revenue, EBITDA, EBIT, or net income. The amount of the purchase price that is deferred depends on the nature of the transaction. However, factors that can affect the amount of the payment deferral are transaction size, valuation gaps, and the riskiness of future cash flows.
The timing of an earnout varies depending on the deal. Many investors structure the earnout around their planned investment horizon. It can also depend on key future events that significantly impact business performance. For example, this could include the launch of a major new production project.
Challenges of earnouts
The obvious issue for the seller is that a significant portion of deal compensation may be deferred potentially for years. This undermines the immediate financial benefits of the transaction . Another issue is that both the buyer and seller can have incentives to manipulate earnout triggers to raise or lower the payout. This may not be in the best overall interests of the business.
If the seller controls the business and the earnout is revenue-based, the seller could increase costs to boost revenue. Therefore, this improves personal gain but harms overall performance. Conversely, if the buyer controls the business and the earnout is financial-metric-based, they might adjust costs to reduce payouts to the seller. Even when the seller controls the business, external factors like commodity price fluctuations, which are beyond the seller’s control, may affect earnout targets.
Conclusion
Despite potential drawbacks, the earnout remains an important mechanism in agriculture M&A deals when parties cannot agree on valuation. Properly structured, an earnout can help the parties share risk. However, more importantly, align the interests of both buyer and seller, helping ensure both parties benefit in the post-sale period.
Article written by Darin Bifani.