Avoid the Pitfalls of Earnouts and Seller Financing
Over the past year, the market for mergers and acquisitions among small and mid-sized businesses has seen a slight increase. However, despite the uptick, many would-be business acquirers are still quite risk-averse, and want to minimize the amount of capital they need to invest in order to buy a company. To achieve these goals, a buyer may propose a transaction that includes an earnout, where some percentage of the price is contingent upon the future performance of the company. They may also suggest seller financing, where the buyer makes future installment payments to the seller for some portion of overall price.
Not surprisingly, most entrepreneurs who are entertaining the potential sale of their company would much prefer to be paid in full, in cash, at closing. However, if you are considering a sale, an earnout or seller financing may help increase the overall valuation of your company, as a buyer may be willing or able to pay more for a business if a portion of the purchase price can be paid over time.
If you receive an offer to acquire your company that includes an earnout or seller financing provision, the initial challenge is to balance the overall attractiveness of the offer with the very real risk of not receiving some of the post-closing payments if the buyer does not continue to successfully operate your business. Carefully negotiating each component of the earnout or seller financing provision can help to increase the chances of successfully collecting the post-closing payments.
In an earnout scenario, a portion of the purchase price will include some future payment or consideration that the seller will receive if the company achieves certain defined future goals. An earnout reduces the buyer’s risk, because it reduces the purchase price of the company if the agreed-upon future goals are not met. An earnout can also be a useful tool if the buyer and seller can’t come to an agreement regarding valuation. If the company continues to perform, the price the buyer paid goes up, but if the company doesn’t perform, the price goes down.
Setting the goals. An important first challenge to overcome is for the buyer and seller to agree on the goals tied to the earnout. For sellers, basing the earnout on future revenue or sales is usually more attractive than an earnout based on future income or profit, as the buyer will probably be in a position to control expenses and impact income. But it’s also important to include a clear definition of revenue, including revenue recognition methods. For example, for the purposes of the earnout, is revenue to be recognized when the customer is invoiced, or when payment is received? A seller may also prefer an earnout that is based on a sliding scale, with payments based on a percentage of the milestones achieved, rather than an all-or-nothing goal. A buyer may propose an earnout that includes a cap on the maximum amount the seller can receive, so that if the company does perform very well under the new owner, the payment to the seller has an upper limit. It’s also important to agree how frequently the earnout will be paid. A buyer may want an earnout to be paid annually, while a seller may want payments made quarterly, or even monthly.
Be careful what you wish for. If you’re in the process of selling your company, you’ve probably tried to help the buyer understand your optimistic view of the future potential of the business. However, it’s important that any projections you share with a buyer are realistic, because the buyer may incorporate these same projections into an earnout proposal. As a seller, you can easily find yourself in an awkward position if you won’t agree to compensation based on the future performance you recently assured the buyer that the business can easily deliver.
Earnout provisions are particularly common with the sale of professional services companies, such as advertising and public relations agencies, consulting companies, technology companies, and any other businesses where the client base will need to be transitioned to the buyer. An earnout provides the buyer with the comfort that the purchase price will be reduced if some of the clients don’t transition their work to the new company, and ensures the seller has an incentive to work with the buyer to transition the clients.
A seller who will continue to play an active management role in the business, and who has some real level of control over the future performance of the business, may be more open to an earnout provision than a seller who will be leaving the business completely after a short transition period.
Seller Financing Considerations
In a business sale that involves some seller financing, the seller provides the buyer with a loan or promissory note at an agreed interest rate, for a portion of the selling price of the company. Seller financing is generally more common in smaller transactions, where the buyer is possibly an individual or a small company, rather than a large corporate acquirer. Unlike an earnout, the future amounts to be paid are fixed, and do not vary based on the future performance of the business. However, the principal and the interest on the loan are generally paid from the proceeds of the business, so if the business doesn’t perform under the new buyer, there is still significant risk that the seller might not receive the future payments.
Guaranteeing the payments. Like any lender, a seller who is considering providing financing to a buyer should understand the financial history and personal net worth of the buyer and his or her spouse. A seller should also ensure the payments are guaranteed by the business and by the buyer personally, and ideally, backed-up by real estate or other tangible personal assets. An entrepreneur may be comfortable providing financing to a buyer with significant personal assets who has successfully operated a similar business, but hesitant to enter into a similar transaction with a buyer with no personal assets to pledge against the loan, or no previous industry experience.
Subordination. If the buyer will also be seeking other sources of financing, such as a bank or a Small Business Administration loan, the bank will likely want the seller financing to be subordinate to the bank financing. This means that if the buyer defaults, the bank will be first in line to get paid—before the seller.
Understanding the issues involved with earnouts and seller financing, and addressing the needs of both the buyer and seller, can help overcome the understandable tension between the seller’s desire to receive as much cash as possible at closing, and the buyer’s interest in reducing the amount of cash provided at closing.
Sally Anne Hughes is the founder of business brokerage firm Hughes Klaiber LLC. She represents business owners in all aspects of business sales and acquisitions. She can be reached at email@example.com.