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Seller Notes and Earn Outs

Posted by Tom Howard in Articles

Today we are going to discuss seller notes and earn-outs, which can oftentimes be an integral part of the acquisition structure used by buyers of Internet and Technology Companies.

Seller Financing is a normal part of the selling process for most small businesses. Rarely, if ever, do sellers get the opportunity to receive 100% of their full asking price at Closing. The reasons for this are varied, but they include the fact that if the transaction is backed by the SBA (Small Business Association), then the preferred SBA lenders prefer some level of owner financing. Additionally, buyers tend to want a seller to keep a certain level of equity or ownership in a company after a sale to ensure that the seller maintain an interest or stake in seeing the company continue to financially operate successfully.

In the acquisition of a business, the purchase price is paid in a number of ways, including cash, debt financing (bank), seller promissory note, earn out and equity financing (shares). For today’s segment, we’ll focus on the Seller Promissory Note and Earn Outs.

Seller financing in the form of a promissory note usually includes a loan from the seller to buyer at a certain interest rate written on a promissory note form. If the primary deal is being financed via an SBA loan, then the Seller Note will have to take a secondary position to the SBA loan. Usually there is a requirement for the Seller Note to be put into abeyance for a period of time, usually 2 years, and then the Seller can begin taking payments. We have crafted strategic arrangements with parties to work around the abeyance requirements to ensure all parties are happy with the process at Closing.

Payments on Seller Notes are usually fixed according to the agreed-upon interest rate. In some cases, these seller notes, and the payments made thereunder, are made contingent upon the financial or other performance of the business. This can take many different forms and our expert staff of deal makers can assist in structuring this pursuant to the parties wishes.

Earn-Out scenarios are a little different. They usually include variable payments based on the future performance of the business to be sold. The seller faces the prospect of lost payments should the business under-perform while in the care of the new owner, so for this reason (amongst many others), it’s important that the parties have a great working relationship not just during the pre-Closing stage, but also after Closing.

A typical earnout scenario would be one where the company’s Gross Revenue is measured against historical Gross Revenue in order to arrive at a top line growth rate. In such a scenario, an earn-out might be due to the Seller should certain metrics be met on this top line analysis. We have also structured these on earnings comparisons, but they can be far trickier for the parties, post-closing.

Contrary to popular belief, most seller financing and earnout arrangements do not incentivize a Buyer to purposefully cause the business to under-perform. The reason is that such a loss will usually be quite severe for the Buyer, as well. However, fully ensuring the parties are covered per their wishes for such contingencies requires a sharp eye to the details of the contract. Again, that’s where we can help based on the experiences we’ve had in selling hundreds of companies.