By Ron Martindale Jr. & Louise Poole, Davis Martindale

When selling a business, common forms of consideration that may be accepted include cash, shares of the acquiring entity, assumption of debt, contingent consideration (earn-outs), holdbacks, and promissory notes. As one would expect, sellers prefer to receive as much upfront cash as possible, whereas buyers prefer the payments to be spread out, like a bank loan or a house mortgage, and to be contingent upon the business’ future performance. Accordingly, to appease both parties, several types of consideration may be used in a deal, the combination of which depends on multiple factors, which include:

  • The seller’s interest in investing in the buyer’s business
  • The seller’s tax planning strategies
  • The buyer’s current and projected cash flow resources
  • The negotiating power of the buyer and seller

When a transaction involves a non-cash component, both the buyer and the seller should agree on the implied cash-equivalent value. In addition, there is more flexibility in the compensation that a vendor is able to accept when selling a private company compared to a public company, due to securities legislation. This chapter discusses the different types of considerations available when selling a business.

Contingent Consideration (Earn-Outs)

Buyers and sellers often disagree on the value of a business due to differences in expectation regarding future performance at the time of the sale. Accordingly, contingent consideration is used during acquisition to spread the business-related risk between the buyer and the seller by making a portion of the purchase price dependent on indicators of the entity’s future performance. These are referred to as earn-out milestones. Common earn-out milestones include financial metrics such as revenue, gross profit, or earnings before interest, taxes, depreciation, and amortization (EBITDA). However, earn-out milestones can also be based on other objectives, such as opening a new branch or establishing a contract with a major client. The better the business performs subsequent to the acquisition, the greater the compensation to the vendor. Earn-outs are particularly effective when the vendor expects strong future growth or is interested in remaining involved with the business post-sale, as they can have a direct impact on performance.

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Earn-outs: Structure

When structuring an earn-out agreement, key considerations include the length of the earn-out period, the vendor’s role with the company post-acquisition, accounting assumptions to be used going forward, and financial metrics used to determine the earn-out. There are two common types of earn-out structures:

  • Fixed-amount plus agreements: The earn-out amount is equal to a percentage of the business’ earnings (or other measure) for a specified number of years following the sale. There is typically no maximum amount payable with this approach, which could be advantageous to the seller and disadvantageous to the buyer.
  • Price abatement and warranty type agreements: Given the above, a cap is usually placed on the quantum of the earn-out. These agreements impose a price reduction and/or penalty on the seller if the business does not meet the earn-out hurdles outlined in the agreement.
Earn-Outs: Advantages and Disadvantages

 

Buyer

Seller

Advantages

- Longer period of time to pay for the business

- Less consideration if business underperforms

- Potential deferral of taxes as full consideration is not received at the time of sale

Disadvantages

- The seller may want to stay involved with the business, which could create conflict when major decisions are made

- Compensation is tied to future performance, which the seller may have little control over

Earn-Outs: Example

Company X had $100 million in sales and $10 million in net income during 2021. A potential buyer is willing to pay $500 million. However, the current owner believes the business is worth $700 million after considering synergies, goodwill, and future growth. To facilitate a deal and spread the risk between the buyer and seller, an earnout could be implemented. A potential deal might be for an upfront cash payment of $500 million and an earn-out of $200 million if sales reach $300 million within a two-year window, $100 million if sales only reach $250 million, and no earn-out if sales are below $250 million.

Holdbacks

Holdbacks are common in transactions involving private companies and tend to range from 5% to 15% of the purchase price. To reduce the risk of non-payment, holdbacks are often placed into an escrow account until the conditions attached to the holdback are met, typically lasting from six months to two years. Holdbacks are designed to protect the buyer from post-acquisition issues such as insufficient working capital, hidden liabilities, contingent liabilities, and the overpayment of shares.

Vendor Take-Backs

A vendor take-back occurs when the seller agrees to receive a portion or all of the purchase price over a period of time. This is effectively an alternative financing strategy for the buyer. Vendor take-backs commonly take the form of promissory notes and redeemable preferred shares and can be valued at a price discount or price premium depending on industry and company-specific risk factors. Although vendor take-backs can be of any length, they typically range from three to five years, and vary in terms of the timing of regular payments and interest.

Promissory notes are often considered unsecured debt, ranking behind debt and other creditors, and therefore need to be priced accordingly given the non-collection risk the seller is exposed to. In addition, promissory notes can be structured similarly to an earn-out in that it may only be paid out if certain performance metrics are met.

Conclusion

When buying or selling a business, different forms of consideration can be used to help facilitate a deal. Earns outs and holdbacks are a common form of contingent consideration, which helps shift the part of the risk of the transaction from the buyer to seller and bridge the gap between the buyer’s and seller’s expectations. Other forms of consideration, such as vendor take back loans, help facilitate the  transaction by being an alternative form of financing for the buyer.