Almost all buyers prefer earn out, while most sellers want to avoid it like the plague.
When it comes to the deposit, the roles are reversed.
Many, if not all, sellers claim excessive potential.
How do you navigavet this jungle?
What usually goes wrong when selling a business?
Many business transactions involve some form of earn-out, vendor note, or deferred payment.
Seller’s note: is a loan that the seller gives to the buyer. This in itself is not necessarily wrong, it’s all about the conditions. There is a big difference if only the company in question is used as collateral, or if the buyer personally guarantees the debt, combined with the fact that the buyer owns a property and/or other companies. Too many seller´s note come without such guarantees, and those should be avoided.
Deferred payment: is exactly what it sounds like, but it is more of a general definition, that is somewhat unspecified. Again, it is all about the deal structure. Is the deferred payment subject to offset? Is it subject to the profits? or adjusted profits? Because it is an earn out, not deferred payment.
Earn out: is a definition that sometimes overlaps with both earn-out and seller’s note. An earn out is linked to a pre-defined performance, often revenue or profit. It is easier to justify linking an earn out to profit, but it is safer to link it to revenue.
All of these terms: are used by many people synonymously with each other, which you could of course argue is a bit sloppy. However, what really matters are the terms of the future payment and the creditworthiness of the buyer. This is commonly overlooked, because the seller has tunnel vision on the headline price, which is a mistake.
If you are selling a business for the first time, you will receive many offers that include one of these definitions. As independent M&A advisors, we are not ashamed to address the issue early with the buyer, which also includes seeing the buyer’s proof of funds.
The size of the deferred payment may vary, but since it is often becomes an issue down the road, it is a sensible approach to limit it to no more than 20% – 25%.
Deferred payment is often something of a necessary evil, preferred by buyers but disliked by sellers. This often leads to conflicts afterwards.
On one hand, you often lose buyers if you demand 100% cash on closing, and unlike a real estate deal, you can rarely afford to lose buyers because it can take months or even years to find a new buyer.
On the other hand, it is important to remember that there will often be conflicts related to the deferred payment, and the average seller underestimates the risk. Oftentimes, what they don´t receive on closing day, they may not receive at all.
A reasonable starting point is to avoid deferred payments, but it is not always that simple. Less attractive companies are often difficult to sell as they are, and it is not always possible to close the deal if you demand 100% cash on closing. When it comes to attractive companies, you often have the opportunity to avoid it. Some buyers have more room for negotiation than others, but it is not uncommon that you end up in a situation where you get the same amount on closing day, without the “extra bonus” afterwards. In such case, you may want that extra bonus, if you are selling the company.
Pro-tip: Unlike many other deals, you rarely get everything the way you want it, when you are buying or selling a business. Some larger private equity firms may get most of their terms in the deal, but then you might be looking at strategic value or investment value, which in plain English means a higher price. You need some level of flexiblity if you are going to be successful at closing deals, which is why it may be a bad idea to immediately shut the door, for any deferred payment.
Last but not least. It is common, not to say “standard” that all sellers exaggerate the potential of the company they have built. They have often invested much of their life in the company, and they look at it in much the same way as they look at their child. The difference between the sustainable profit and the claimed potential should, as a rule, always be handled with an earn out. It is almost always the buyer who proposes, demands, or binds his bid in a (partial) earn out.
Negotiation of legal risks and responsibilities
The legal risks are also an important part of the agreement and the negotiation. It is common for the draft agreements to be very one-sided, in favor of the person who wrote the draft. What is reasonable can vary greatly from transaction to transaction, but there are some things that always come up.
1, Misrepresentation of the company, with personal liability. In plain English, this means everything that the seller and/or broker claims must be true. It is perfectly reasonable to hold the seller personally liable for misrepresentation of the company. Sometimes they are willing to agree to this, sometimes not. If they are not willing to go along with it, then that should be considered as a red flag.
Some business brokers have disclaimers regarding the responsibility and these are often ok, both legally and morally, but it should be carefully noted and communicated to all parties involved, especially to the seller. It is common for the seller and broker to blame each other, which makes it extra important to clearly communicate what is expected in writing.
2, Minimum limit for dispute. Sometimes both buyers and sellers underestimate how expensive litigation can be. It may take years and cost six-figure sums. One therefore usually sets a minimum limit for what is worth arguing about. This limit varies depending on deal size, but is usually anywhere from $5,000 to $50,000.
3, Responsibility for what happened up to the transaction date. Here it is somewhat difficult to express oneself regarding what is reasonable and what is not. If nothing is agreed, all risk lies with the buyer. All companies are unique, and have unique risks. Each case should be looked at individually. There are also M&A insurances to buy.
Want to go with a cheaper option or even do the valuation yourself? Nothing is stopping you, but...
You may lose the lawsuit, due to the valuation failing to be waterproof.
You may never settle the conflict, hurting the relationship with your counterpart.
You may get deceived while entering or exiting your partnership.
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