Since share price volatility is usually easily observed based on historical traded prices of comparable industry companies, price volatility typically serves as the starting point of volatility estimates for other metrics, such as EBITDA and revenue.
Simply put, volatility and risk increase as you go down the income statement. Revenues pose relatively low volatility and modest risks while EBITDA, which introduces operational leverage, poses higher volatility and more risk. By adding financial leverage in moving down the income statement from EBITDA to net income and price per share, net income and price introduce an even higher level of volatility and risk.
Since share price volatility is usually easily observed based on historical traded prices of comparable industry companies, price volatility typically serves as the starting point of volatility estimates for other metrics, such as EBITDA and revenue. To determine EBITDA volatility, share price volatility is adjusted for financial leverage. Similarly, to determined revenue volatility, share price volatility is adjusted for both financial leverage and operational leverage.
Since operational leverage differs from one industry to another, the same price volatility for two companies with vastly different operational leverage will result in significantly different revenue volatility. One company with large operational leverage (high fixed costs) may have a less risky revenue-based earnout; another company with very low operational leverage may have a very risky revenue-based earnout, all else equal.
While both parties have differing interests in earnouts — one company’s risk is another’s leverage — they have a shared interest in avoiding unnecessary disputes, which can be costly and distracting. Acquiring companies have an obvious interest in setting caps that limit the earnout payout. Target companies have an interest in renegotiating caps that deprive them of the benefit of predictably robust performance and hurdles that eliminate payouts for de minimis shortfalls in revenues and earnings. Overestimating the earnout as of the transaction date will overestimate the goodwill, making the early impairment more probable. As such, it is important to consider the facts outlined above when negotiating and valuing the earnout as of the transaction date.
Oksana Westerbeke, Valuation & Modeling principal at Grant Thornton, explained: “In a time of volatility and continued uncertainty in the market, everyone has an interest in informed decision-making and fact-based negotiation that will provide the most stable outcome and lower the chances of later being disputed. Ultimately, Monte Carlo simulations are better suited to delivering the valuations that make that possible.”
While each transaction has unique characteristics, a Monte Carlo simulation is the presumptive choice when structuring, negotiating and valuing earnouts.