Some straight talk about seller notes and earn outs
Many business brokers, CPAs, and bankers will tell business owner clients to expect a seller note or an earn-out when they sell their business. In general, Codiligent views both seller notes and earn-outs as having a high level of risk. If a business has significant risk factors and marketability challenges a seller note or earn-out may be warranted. However, if a business has low risk factors and is highly marketable, earn-outs and seller notes should be kept to a minimum to reduce risk to the seller.
A seller note is a loan provided to the buyer of a business by the seller. The loan is evidenced by a note / loan agreement documenting the agreed upon terms of the debt. Typically, the buyer makes a down payment, with installment payments thereafter. Terms can vary significantly from interest-only payments with a balloon, to fully-amortizing equal principal & interest loan payments. Most seller notes are generally between three and ten years in duration, are often secured by the assets of a business, and may include a personal guaranty from the buyer. It is worth noting, in cases when traditional bank debt is used to finance a portion of the business sale, that the bank will require that the seller note be subordinated to the bank’s debt. Subordinating the seller note allows a bank to have priority status in the event of a default.
When advertising a business for sale, offering a seller note increases marketability. Business sale websites have filters allowing buyers to search for businesses that offer seller financing. Many buyers perceive that if a seller isn’t offering at least some level of seller financing, it’s an indication that the seller is not confident of the business’ future performance. Codiligent disagrees with this – but it is a commonly-held buyer perception.
There are some benefits of utilizing seller notes which may include: 1) increasing the buyer pool to encourage more competition, which could result in a higher sale price; 2) improving the probability of selling the business; 3) providing a seller with future income in the form of loan payments; and 4) spreading income out into future years which may allow a seller to move some of the business sale consideration into lower income tax brackets. Additionally, there are companies that will buy seasoned performing seller notes, but prices are often discounted by 15% to 30%.
An earn-out refers to a pricing structure where a portion of the sale price is based on the performance of the business after the acquisition based on the company achieving certain negotiated conditions. Some examples include: reaching, or maintaining, a certain level of revenue, customer or employee retention, or the approval of a pending patent. An earn-out usually poses a greater risk to a seller than a note, but in cases where there is significant risk to the buyer or where the seller would like more potential upside, an earn-out can be appropriate.
Codiligent strives to find financially well-qualified buyers for the businesses it represents. Historically, Codiligent has successfully negotiated the sale of many businesses without utilizing seller notes or earn-outs. In cases where seller notes have been utilized, the average note has been less than 11% of the transaction compared to the industry average of 43%. Only in rare instances have earn outs been utilized on Codiligent-represented transactions.
Following are two short videos about earn-outs: