- March 27, 2013, Gary Hermsen
In my last article [Ready to Sell? Don't Take Your Foot Off the Gas Now!], I talked about transitioning out of your business and how the buyer may want you to remain with the company as an employee or in a consulting role for a year or so to help transition the business knowledge, relationships, etc. It is also fairly common for you to be asked to assist in the financing of the deal via seller financing, earnout, or a combination of the two.
What is Seller Financing?
When a buyer makes an offer on a business, they are typically prepared to spend some of their own money for a down payment and will get a lender to finance most of the purchase. Seller financing is most often used to bridge the difference between the purchase price of the business and what the buyer brings to the table in the form of a down payment and bank financing. It is also seen by most buyers and lenders as an indication that the seller has faith in the future of the business.
The seller is acting in much the same way as a bank in terms of financing the transaction; however, the seller is always in second position behind the bank. For this reason, sellers can usually get an interest rate that is a point or two higher than the bank rate. In addition, the seller and their legal counsel may secure the note with personal guarantees or some specific collateral that the lender doesn’t already have tied up. The terms for seller financing notes will vary depending on the deal. They usually run for 3–5 years with a balloon payment, yet they will be amortized over a longer period of time to keep the payment lower and more manageable for the new owner. The lender also may require that seller note payments be interest-only payments for the first year or two if cash flow appears to be tight.
What is Earnout?
Earnout is a variable part of the price paid for a company. It is tied to the future performance of the company. Earnout is most often used when the seller has recently landed a significant piece of business or acquired a new piece of equipment that will bring additional revenues. Historically the company hasn’t seen the increase in revenues and profits, and therefore would not expect payment up front for such increases. In either case, the performance of the company is expected to be much greater having these things in place.
From a buyer’s standpoint, they would prefer to tie an earnout to net profits as they know that the cash flow is there to support the additional payments. The seller however would prefer to tie the earnout to revenues since the expenses could potentially be manipulated to show no significant increase in profits even though the revenues have increased. The fairest way for both parties is to tie the earnout to gross profits while agreeing to what constitutes cost of goods sold.
In a few instances you may be able to find a buyer that offers an all-cash deal. However, in more cases than not, in order to get the highest price, the seller is asked to assist via seller financing or earnout. In other words, a little more risk for potentially a much greater price.
Gary Hermsen is a mergers and acquisitions advisor for Cornerstone Business Services. He has 13+ years of experience in the converting industry as an owner and former owner/operator of a paper converting company and more recently as an M&A advisor to others in the industry. Contact him at 920-436-9890; firstname.lastname@example.org.