One of the most common scenarios in a business transfer is for the seller to offer the buyer some kind of financing option. Whether it’s term financing or a seller earnout, offering a buyer the ability to acquire your business at an amount that might otherwise present a barrier to entry is a powerful tool in your exit strategy. Both options allow the buyer to enter the business with more liquidity to add value or adapt the model to their vision, and it gives them peace of mind knowing that the seller has confidence the business will perform as advertised. When you decide it’s time to start thinking about an exit, keeping these strategies in mind can be a vital part of a successful disposition. But which one is right for you?
Gary Miller, CEO of GEM Strategy Management Inc. has this insight of the pros and cons of a Seller Earnout:
Advantages of earnouts
“For a buyer, the advantages of using earnouts are hard to challenge. By deferring payment(s) of a portion of the purchase price and making it conditional on the achievement of certain performance targets, the buyer is actually transferring the risk of the uncertainty of future revenues to the seller. For a buyer, this is the most valuable benefit of an earnout, as it will only pay for those potential revenues/earnings when they are achieved. The frequency of payments and the earnout period are determined by the purchase agreement — usually paid on a quarterly or semiannual or annual basis over a one to three year time period.
Another advantage for the buyer is to use the earnout as a tool to protect itself against misrepresentations or a breach of covenants by the seller. If at some point during the earnout period, the buyer makes a claim against the seller for misrepresentations, breach of covenants or other terms and conditions, the buyer may decide (depending on the purchase and sale agreement) to deduct the amount of its indemnity claim from any earnout payments due to the seller.
Finally, earnouts can help a buyer retain key employees. For example, when the seller is also the CEO of the business, having an earnout would encourage him/her to remain with the company after the transaction closes. For the seller, remaining with the company would give more control and a strong personal incentive to do his/her best to meet the performance targets.
Disadvantages of earnouts
The biggest disadvantage of earnouts is the risk of post-transaction disputes. Typically, the disputes center the seller’s ability to achieve the earnout performance targets. More often than not, disputes arise when performance targets are not met because the buyer (at the shareholder level) makes certain management decisions that prevent the acquired business from achieving its performance targets.
Structuring the earnout can be a serious challenge too. If the earnout is not tailored to or in alignment with the uniqueness of the businesses operations, complications followed by disputes can arise. Since each business operates differently, even when operating in the same space, special attention to operating details is required for a successful earnout structure.
Although the risk of earnout disputes is difficult to eliminate, earnouts work best when a seller-CEO stays with the acquired company after the transaction closes because: (1) a continuity of management practices will be in place; (2) the risk of disputes based on the seller’s lack of control over the company’s operations is reduced and, (3) the seller will be rewarded for his/hers own performance rather than for the performance of a new management team brought in by the buyer.
Most importantly then, one should think of an earnout as creating a partnership between seller and buyer. If an earnout is structured properly, the buyer and seller become partners, sharing in the upside and downside risk of a deal.
If you are more interested in being able to completely step away from your business, you might want to consider the advantages and disadvantages of term financing.
Business.com states the following items to weigh when offering terms:
Advantages for the Buyer:
- An affordable monthly payment provides the new owner with some breathing room to use cash flow to pay bills and cover expenses while getting the business established under new ownership.
- The balance due at the end is more likely to obtain traditional loan approval to refinance than would the initial loan.
- The interest paid often isn’t different than what would have been paid to a bank
- Sellers still have an interest in the success of what was once their business, which provides purchasers with a built-in source for advice and guidance that doesn’t cost them anything extra.
Advantages for the Seller:
- The seller earns interest on top of the amount asked for the business. In most cases the interest earned is equal to, if not higher than, other investment options.
- Income taxes are lower than they would be if you were paying on the total sale, since you are only paying taxes on payments received over time.
- The business can be sold to a buyer who, while qualified to run the business, cannot qualify for a traditional bank loan.
- The sale happens faster and the desire to get out of the business is realized more quickly.
- The seller maintains some stake in the business during a transitional period to help ensure the enterprise continues to succeed and serve customers.
Why Owners Might Not Want to Offer Seller Financing:
- There’s more risk involved. When the purchaser finances with a bank loan, if the buyer defaults, that’s the bank’s problem. The seller already has the money. (One way to mitigate risk is to require business assets as collateral or demand a significantly higher down payment).
- Sellers maintain a vested interest in a business they may have preferred to make a clean break from.
- There is less immediate capital to reinvest. Sellers who need significant capital to invest in new ventures aren’t likely to provide owner financing.
Whether you choose and earnout or financing it’s important to understand the risk and rewards of both strategies. While either option will greatly improve your odds of a successful sale, they aren’t without potential problems. Sperry CGA – Griffin Partners can’t tell you what is right for your particular situation, but once you make that decision our experts can guide you through the rest to maximize your selling price and ensure a smooth transfer.