Earnout or Seller Financing: Which is better for your business sale?

When structuring a business sale, a common problem that arises is a difference in opinion on the value of the business. It's important to recognize that the two parties are motivated by different information. Buyers are focused on past earnings and the operational risk in the business that will affect future earnings. Sellers typically focus on the company's recent historical performance, hoping to maximize their profit from the sale.

This difference in focus can make it difficult for either side to find balance between the amount that a buyer is willing to pay and the amount a seller is willing to accept. An earnout or seller financing can bridge the value gap, yet each has its own pitfalls and advantages.

Of course, an all cash deal at full market price would be a dream for any seller, but the reality is that these two innovative financing solutions are often the magic that makes many business acquisitions happen. Read on to determine which financing solution is best suited for you and your business.

Seller Financing

Seller financing is when the seller agrees to finance a portion of the purchase price over a set period of time. The amount due in the future is defined and capped, limiting the upside, but protecting the seller's interests by establishing a repayment schedule.

This option is best suited for a departing owner that wants the security of a guaranteed repayment schedule.

Businesses with steady sales and operating profits are a good fit for this type of acquisition financing solution. By offering this repayment option to a buyer, it widens the buyer market, increasing the chances of multiple offers and a higher selling price.

When there is a shortage of bank financing or the need for multiple financing options, this is when seller financing is vital. Buyers are increasingly asking sellers to finance a portion of the purchase price as a means of bridging the value gap. The buyer has to come up with a portion of the total price up front and the remainder over time. It is typical for a seller to finance one-third to two-thirds of the sale price within a three to five year term.

Here is a look at some of the benefits and risks associated with seller financing.

 Benefits:

  • A seller has access to the full purchase price, which might otherwise not be possible.
  • Businesses typically sell for 15% more when seller financing is provided.
  • Sellers can earn 8-15% interest over a five to seven year period, resulting in increased compensation from the sale.
  • Security over non-business assets can be requested to guarantee repayment.
  • Bank financing options are more likely with an increased amount of equity in the deal.

Risks:

  • Success under new ownership is not guaranteed and the seller will have money at risk. Finding the right buyer that has the appropriate skills to take over the business is important.
  • A buyer may be unable to make the scheduled payments. A carefully crafted agreement can protect the seller's interests in this worst-case scenario.

The bottom line:

This creative financing solution may be the best fit for you and your business if you wish to successfully sell your business and its goodwill. Acquiring lender financing for goodwill can be tricky, but if designed correctly, this option increases the probability of lender financing.

 Earnouts

An earnout is where a portion of the purchase price is paid after the closing, contingent in whole or in part on the target company's financial performance over a specified period of time.

Earnouts are common in about 80% of acquisitions and typically represent about one-third of the total transaction value. They are typically based on the projections that the seller prepares as part of the sale and/or due diligence process. Earnouts are structured as a percentage of a mutually agreed upon financial metric.

Earnouts are typically suited for high growth businesses where future financial results are difficult to model.

Despite having a compelling reason to sell the high growth business (which is key), the owner has a firm belief in the company's future potential. As such, they are willing to take on the risk that it will perform to its expectations, even under new ownership. Earnouts make the buyer believe in the future of the business.

 Benefits:

  • No limit to seller profit.
  • No increase in buyer risk.
  • Helps protect a buyer from overpaying for a business. If a milestone is missed, the additional consideration is not paid.
  • Protects a seller from selling too cheaply. If the business continues to perform well and milestones are achieved, the seller gets additional compensation over time.

 Risks:

  • Earnouts are often more complicated and risky to the seller than seller financing, as future payments are not guaranteed or collateralized.

Earnout negotiation points:

Unique to the structure of each earnout is the selection of a target metric, which is typically revenue, EBITDA, or gross profit. Each represents varying levels of risk to each party in the transaction and as such, this determining metric must be wholeheartedly agreed to by both seller and buyer.

Revenue is the easiest metric to measure and the most difficult to manipulate from a seller point of view. Buyers are hesitant to offer this metric, as it doesn't account for whether the revenues are non-recurring or if margins are acceptable. This option is best suited to a buyer who is in complete control of operations after the transition; that way they can control the margin and overhead costs of the business. Sellers typically prefer this metric as it removes the risk of poor management by the buyer.

EBITDA is a commonly used metric for earnouts. A buyer may prefer this metric because it shares remaining profit and corresponds closely to real world cashflow success. On the other hand, a seller may be focused on growing the sales and therefore have preference for a revenue or gross profit threshold. The potential risk associated with this metric is that it is the easiest to manipulate. The "E" (earnings) could be padded with expenses that the seller may not have incurred while running the business. To reduce this risk, unique clauses can be devised to protect a client from expense manipulation.

Gross Profit is often referred to as the "compromise" metric because it's not as easy to manipulate with general expenses. This approach is more appropriate for businesses with stable overhead levels. As long as it is the accurate gross profit of the operation, both parties' interests should be protected.

The bottom line:

The most important takeaway is that precise and careful drafting of the earnout clause is key to minimizing and eliminating disputes. With the right guidance from experienced advisors, the earnout should be viewed as a powerful tool in price negotiation. Although seemingly complex, it is often the most flexible risk-sharing mechanism to bridge valuation gaps.