Not all offers are created equal – in fact, we’ve never received two identical offers while running a formal sell-side process. As a seller, it is critical that you fully understand the more complex elements of an offer in addition to total proceeds. These include specific structure and timing of the payments and potential risk. Too often, we see clients fixate on the purchase price while overlooking the impact deal terms have on overall consideration. In the lower middle market, contingency payments, seller financing, or rollover equity are commonly included as part of the total payment structure. While most sellers prefer to receive guaranteed payment at closing (cash is king), you may be able to elicit maximal value by receiving additional consideration in a more unorthodox manner. Here, we cover high level attributes of common deal terms you may encounter. Stay tuned for future blog posts that tackle each topic in greater detail.
Earn Out & Contingency Payments:
Essentially, earn out is a performance-based incentive paid over time to offset perceived risk in a transaction. Often, we see earn out used to bridge a valuation gap or to protect the buyer from potential downside in a high-risk deal. Customer concentration and rapid, recent growth are two common business characteristics that legitimize the use of contingency payments, however there are several other variables that justify earn out. For example, if one of your customers generates 40% of annual revenues, a buyer will likely structure the deal with some earn out to offset the risk tied to such a large account. Typically, we see earn outs paid over one to three years, contingent on meeting financial thresholds such as revenue milestones or gross profit levels. As a seller, you should give strong consideration to your ability to meet the earn out targets and what involvement, if any, you’ll have in the future operations of the business once sold.
Seller Financing:
Seller financing, in its simplest form, is the process of the seller acting as the bank. For many buyers, the ability to finance a transaction is limited by the debt available from traditional lending sources. When adequate equity is not available to make up the difference in the purchase price, sometimes a seller note is the next best option. Buyer and seller agree to principal and interest payments in advance of the sale, and seller notes are subordinate to any senior loans. The seller determines risk by evaluating the buyer’s ability to generate future cash flow required to cover debt service. If a seller note is subordinate and/or unsecured, it will likely yield a higher interest rate than senior/secured debt. You, the seller, can benefit from these high-interest payments and may also reap the benefit from tax efficiencies on the installment payments. Every deal is unique, however, so consider all variables and consult with your advisory team to ensure you have good protections in seller note.
Roll-Over Equity
If you’re a seller wishing to participate in continued ownership of your business and recapitalize with an equity partner, you can roll a portion of your proceeds into the newly-capitalized entity. Most commonly, transactions involving rollover equity are structured so that “NewCo” acquires the selling entity’s assets and recapitalizes them with both equity and debt. You, the seller, provide a portion of the equity alongside your new investors with the goal of enhancing your equity value through continued growth and appropriate use of leverage. You should examine closely the class and treatment of your equity investment as compared with that of your new investor partners. As a general statement, your equity should be held in the same security with the same provisions as new investors to ensure everyone’s interests are aligned and ownership splits are allocated fairly.
Don’t let total purchase price dictate your decision before closely examining the totality of a transaction and the net impact and associated risk certain terms have on the deal. The highest enterprise value does not always translate to the best deal. In one of the biggest decisions of your life, do yourself a favor and have a professional evaluate any proposal you consider prior to going down the road with a buyer.