Earn-Outs Pt.2: Benefits and Pitfalls of Owner Financing

How do earn-outs help retain the support of the seller, and why would the buyer want to?

By tying the seller’s receipt of the sale price to the ongoing success of the business, the buyer ensures that the vendor has a vested interest in helping out post-sale – passing on all relevant knowledge and expertise, advising on strategy, and introducing the new owner to relevant clients and suppliers.

“We stay in touch with the vendor and seek their advice,” says Roland Stringer, who recently part financed the purchase of a dating agency with promissory notes. “With so many business deals, the deal gets done and you never see or hear of the vendor again.”

Seller financing is therefore, as Richard May of business brokerage TSL Business Sales points out, obviously invaluable “where the purchaser is perhaps concerned that the outgoing owner’s involvement in the business is quite high.”

A good example of such a business is a marketing agency, where the previous owner’s charisma, expertise and reputation are pivotal factors in attracting and keeping clients. If they sever all ties upon sale completion, an exodus of clients could ensue.

Other businesses where the buyer might want the seller to help out for a while are those which have developed esoteric systems, such as certain hi-tech businesses.

Any staff still in situ after the transition will be able to help any new owner of course. But retaining the former proprietor on a consultative basis might be vital for understanding the company’s modus operandi, how it has developed and how it should continue to develop if the company is to thrive.

Ken Walters, a business advisor and broker who trades as The Business Exchange, can vouch from his clients’ experiences that earn-outs are an effective way of retaining the seller’s support.

“I have a client in Birmingham buying a business with a down payment, and the rest is on a monthly basis over five years. He was six months into the deal and some of the customers were not paying quickly enough.

“The buyer then contacted the seller and asked him what he should do. So the seller made a couple of phone calls to the customers and bingo, it was all OK again.

“So from a buyer’s perspective, it is a benefit as the seller is morally locked in, and has a selfish interest to make it work over ‘X’ number of years.”

It is worth noting that you don’t have to offer loan notes to secure the cooperation of the current owner post-sale; you can stipulate in the asset or goodwill purchase agreement, or share purchase agreement, that the seller has to stay on in a consultancy role for a given period. This at least means you can define specifically the scope of his role, although you could argue that the seller will be especially helpful and supportive when his destiny, like the buyer’s, is tied to the fortunes of the business.

So given that the seller has a vested interest in the business’s success, does that mean that a commitment to owner financing represents a vote of confidence in the company?

“It shows the buyer that the seller is confident that the business is successful and therefore he’ll get paid,” says May.

One could also argue that agreeing to take a loan note is a ringing endorsement of the buyer as well as the business. Like a bank, the seller will only want to lend the money to a buyer with the right credentials.

The successful sale of a business is contingent on the two parties trusting one another. Any doubts about the other party’s sincerity will jeopardise the deal.

A seller might claim to be retiring or seeking a fresh challenge – but what if there’s another reason for selling?

What if they’re seeing insidious developments in the business that due diligence (essentially like an MOT) might miss? What if, unbeknownst to anyone but perceptive industry insiders, market conditions are set to become hostile?

Acceptance of loan notes can assuage mistrust of a seller’s reasons for selling as it means that both buyer and seller have a stake in the business’s success. If the business flounders and the buyer defaults on repayment it leaves the vendor back at square one: owning a business he no longer wants.

What are the risks to the buyer?

There is “a slightly bigger risk of fraud” when part of the deal is seller-financed, warns Henry Edjelbaum, managing director of ASC Finance for Business, a finance brokerage.

“Let’s say a £100k deal is financed 70% with bank finance and 30% equity. The vendor agrees to leave £30k in as a vendor’s loan, so the purchaser can acquire something without any commitment.

“Then if you start playing with the figures, and have a slightly artificially increased purchase price, where a value collides with the [earn-out] scheme, then you can have a situation where if property is only worth £70k, value says it’s worth 100k, and if the bank lends 70k, the vendor ends with a higher figure.”

“It just requires more attention from banks to avoid fraud.”

It still seems like the vendor shoulders more risk though...

The spectre of going full circle looms over seller-financed deals.

“There’s personal disruption in a seller’s life if they need to go back and rehabilitate the business,” says Tony Calvacca, owner of New York Business Brokerage, “especially if they’ve moved” to a different region. “It can take a long time to remarket and resell it.”

Another, obvious drawback is that the seller doesn’t get all of his or her money upfront.

“He’s going to have to wait for some of it,” admits May, “so he might not have enough to go and buy something else straightaway.”

So if the seller declines to fund any of the deal through an earn-out, the buyer shouldn’t necessarily infer that he or she lacks confidence in the business...

“There may be other reasons,” says May. “For instance if he has a loan to repay, he can only repay that with a lump sum.”

If a seller declines to take loan notes for his or her business, “the purchaser shouldn’t read too much into it.”

So what incentives are there for the vendor to defer some of the consideration (payment)?

“The seller’s more likely to sell his business quicker, and it may be for a higher price, because he’s putting some funds straight into the deal,” explains May. “It demonstrates a level of confidence.”

By offering to lend some of the sale price, the seller is widening the pool of prospective buyers, making a deal feasible for anyone unable to raise sufficient funds through traditional lenders. Meanwhile, others, impressed by the owner’s apparent confidence in the enterprise, might be willing to pay a higher price.

The payment the vendor receives is boosted by more than just an inflated price, however.

“From a seller’s point of view,” explains Walters, “he can gain interest and therefore be paid more money.”

For example, if they agree to a carry-back note at 8%, over nine years, on a £100k business, the seller will ultimately receive £200k and double their money.

There can also be tax advantages. However, although “there are strategies whereby you won’t get hit by tax," says Walters, "seller financing is fraught with potential tax problems, which can override any other issues.

“Let’s say you were selling me shares from your limited company for £100k. If I agreed a deal and only pay you half of it, the Inland Revenue will tax you on the full £100k.”

Edjelbaum agrees that “there can be tax advantages, but it all depends on the terms of the deal. I can’t really make a general statement about this, so I would advise seeing a professional advisor to find out how it will affect you.”

If owner financing increases the chances of a sale in ordinary times, then the present extraordinary circumstances, where banks are withholding credit from all but the most watertight business proposals, can amplify this benefit.

“In the current climate,” says May, “a seller is rather more likely to get a sale out of it.”

How can sellers maximise their chances of achieving a satisfactory sale? And how are earn-outs set in motion?

Find out in the third and final instalment of the earn-outs series, which began with an introduction to owner financing.