Seller concern with debt structure + wants earn-out to be 'guaranteed'
December 02, 2019
by a lender from Columbia University in Miami, FL, USA
Hey all -
I have been working on a deal for the last 6 months, and we’re at the altar. All the money is raised, legal docs spun up, boxes all checked. My seller has chosen this moment (par for the course, perhaps) to bring up doubts on the funding model (debt + equity + earnout to buy the business). Long story short, he’s never operated a company with debt, and is concerned that in a downturn we’d lose the whole thing. Furthermore, he is seeking guarantees on the earn-out portion of his deal.
Does anyone have examples or structures they have used to help a seller feel more like we’re on the same page? In this deal, I’m keeping him for 3-5 years, so it would not be successful to antagonize him.
from Ohio State University in Chicago, IL, USA
- I have seen Buyers try to base the earn-out targets on a forecast the Seller has provided or helped to create, so that the Seller feels confident to commit to their own numbers. Often I "argue" that I am entering into a transaction on the basis of the forecast Sellers have provided, so they should be able to sign on for those numbers, or the existing deal value could be questioned.
- Often I have prepared a downside case in a financial model to show the Sellers that even in a doom and gloom scenario, fixed costs and debt service will be met. This often yields a statement like "revenue would have to decline 30% or more and we'd have to fail to cut $x in costs for debt service to be pressured". What are the bounds on these two assumptions the Seller is really comfortable with? At the end of the day, all the partners in the deal have to be aligned on the sustainability of the business over the longer term vis-a-vis the transaction price, etc., or there is a bigger issue.
- I have seen Sellers ask for a covenant to be provided "reasonable resources" or something similar, or they get the money regardless of performance. E.g., if the equity holders deny the management the expected SG&A for some reason, they feel the earn-out targets become unreasonable. Is there some basic commitment you can make to the Seller in terms of SG&A/CapEx/other to make them more comfortable?
- I have seen deals structured with "rollover equity" plus options or profits interests which vest according to multiples of invested capital achieved by common holders to incentivize performance but avoid tying managers/Sellers down to a forecast or set investment horizon. This is my preferred structure. I think there are problems with focusing too much on revenue or too much on EBITDA over a set period. Linking upside to increased equity value seems to be the best approach to me.
I have had various attorneys and deal principals tell me that a revenue/EBITDA earn-out will always be paid in full one way or another--either the performance is good and the money is paid to the Seller or the performance is bad and they sue and get it anyway. YMMV.
from The University of Chicago in Chicago, IL, USA
1) If seller is concerned about down economy, then earn-out does not kick in and hence that should not be the issue. His concern may be leverage and debt-service.
2) On earn-out, sellers are often concerned buyer not making the payment even when earn-out is earned. In this situation, you can offer the business or the purchased assets as a guarantee.
3) The common perception is that earn-out is a tool to bridge value-gap. Be careful. This is true ONLY in a situation where the business model itself has fluctuations. Example: a) Project based business. b) High customer concentration with high customer turnover. If a business has a high concentration customer for many years, the seller (and his advisors) is less likely to accept earn-out help mitigate buyer's risk. Seller is likely to get a strategic byer to eliminate/reduce this risk. c) new product, new territory, etc.
4) The risk of downturn can be overcome. First, if the lender is not concerned about the downturn (if they were concerned, they would not lend), seller should be less concerned. Second, depending on your capital stack (i.e. line of credit and term debt), you may be able to show, with a good financial model, that your cash flow may improve with downturn (this surprises most people. The reason is that with a down turn you need less working capital, so you free up WC). My software allows testing such scenarios.
5) Cash + Note should cover price based on baseline business. Earnout should not be used for base business; It should be used to cover spikes, market and economy driven.
6) I hope you are still on the altar or that the deal is done. There are many more other ways to hopefully convince the owner and advisors. Feel free to reach out. .
Mike Adhikari Illinois Corporate Investments, Inc., Mergers & Acquisitions Business ValueXpress, A Valuation and Deal Structure Software P: ###-###-#### , C: ###-###-#### , F: ###-###-#### www.IllinoisCorporate.com www.BusinessValueXpress.com