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:
“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.
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.”
For the Seller
When considering if an earnout structure is right for you, it’s important to think of it as creating somewhat of a partnership with a buyer. Whereas you may not have to be directly involved with daily operations, your exit will reman tied to the success of the business and therefore will always want to monitor the health and performance of the company. Well-structured earnouts will have a buyer and seller sharing in both the upside and the potential downside of a deal. The advantages of using an earnout structure is that not only will you have a significantly higher chance of finding a buyer in a shorter amount of time, a growing business, sold to a capable buyer can mean a significantly bigger total exit price for the seller.
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.
Advantages for the Buyer:
- Affordable payments can allow a new owner to utilize cashflow to grow the business.
- Loan balances are more likely to be approved for traditional financing after an established period.
- Interest rates and origination cost are often lower than SBA or bank financing.
- Sellers still have a stake in the success of the business and will often make their expertise and knowledge available to a buyer.
Advantages for the Seller:
- Interest charged can lead to a higher profit on the transaction.
- There can be substantial tax savings over receiving one lump payment
- Much larger pool of buyers to market to.
- Often leads to a higher selling price.
- Significantly faster closing times.
Why Sellers May Not Want to owner finance:
- There’s considerably greater risk. This risk can often be mitigated by a seller securing the note with collateral. If the assets involved in the transaction are not adequate to cover a default of the loan, we recommend additional collateral such as real property or securities.
- Sellers might not be able to make a clean break from the business, and sometimes need to engage in advice or problem solving.
- Sellers looking to reinvest profits into another asset will have less working capital.
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. SperryCGA – 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.
By Chris Springfield
SVP Business Acquisitions & Exit Advisory
Sperry Commercial Global Affiliates – Griffin Partners