Earn-out workarounds? (forgivable note, side letter, erosion clause, etc.?)

December 01, 2020

by a searcher from Harvard University - Harvard Business School in Boston, MA, USA

I'm looking at a deal with significant volatility in###-###-#### 2x previous years), and unsurprisingly the owner claims the change the structural and wants to be paid for it. I'm looking for a way to de-risk the deal based on an "earn-out" while using an SBA loan.

The easy answer here is that earn-outs are explicitly prohibited, but I keep hearing about potential work arounds where you can get the same function without it being considered as an earn-out by the lender.

Thanks in advance for the help.

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Reply by a searcher
from University of North Texas in Campbell River, BC, Canada

In my VC days, using a variation of what ^redacted‌ did to make everybody happy. For me, this was in Canada so clearly different rules, no SBA loan (BDC in that case), etc. With respect to the the numbers, top line is the cleanest as you'll have the most control over variable. Top line (revenue) is straight up. The other observation is how much control do you have. By that I mean if the owner is an employee or still active after you close the deal, creating top line with crappy margins get him/her over that revenue number but is it 'good' revenue meaning good margins, contribution, etc. Good luck and happy to provide more perspective as you'd like. redacted

Reply by a professional
from Northwestern University in St. Louis, MO, USA

I agree with Colin McNulty. I've used a 12 month post-closing purchase price adjustment in the purchase agreement and corresponding note reduction as a work-around and could share examples as well. A couple of other things to consider###-###-#### I'd recommend using revenue as the metric rather than EBITDA or net income. Because there's less opportunity to manipulate revenue, it's much easier to negotiate in the definitive documents and avoids potential arguments, and 2) This structure may impact the fees the Seller may owe to his or her investment banker/business broker, so you want to make sure you both stay in front of that issue and you don't have a closing day blow-up. You can reach me at redacted if you want to discuss further.

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