Earn outs are OUT, So what is IN?
By Steve Mariani
This should not be new news to anyone that has been in this industry for any length of time, they were classified as “ineligible” about 5 years ago. In today’s article I will describe the reasons there out and the thinking behind it.
In my 20 plus year SBA career I have structured, witnessed and been included in about 25 or 30 cases of earn outs for different reasons. The most common reason being incredible and recent growth in the last 2 years prior to the sale. The one that instantly comes to mind was a sleep accessories business that had grown at a good rate for many years but then featured on a TV talk show, if memory serves me, I think it was Oprah (don’t quote me). Once that episode aired the sales took off and the company just exploded from mostly individual sales to corporate sales and they began receiving huge orders. So much so that it truly scared the seller who started this small company as an extra income solution in his garage. The buyer, a very savvy corporate executive with strong management skills fell in love with this business knowing he was the perfect leader for it. As you can imagine the selling price increased by a multiple of almost 3 based on having these corporate orders in hand. The dilemma was the valuation and historical cash flow to support the new loan debt, it just wouldn’t cover it. So I was left with a great buyer, strong business and just needed a price that would work. What we structured was a selling price based on historical cash flow and added an earn out for residual cash paid to the seller post-closing based ONLY on the increased revenues. A match made in heaven and it worked perfectly for all parties. That same scenario today is ineligible and here’s why. Back when this was structured the amount of the earn out was removed from the purchase price and by default lowered the down payment. The SBA also had no set amount of required down payment at that time. Once the SBA implemented the 25% down rule their belief was that borrowers would be using an earn out to reduce the selling price and thus the down payment amount. I have not witnessed that myself but it was soon after this rule showed up.
Let’s talk about the effects before we discuss the solution. Today that same business that I described above would to have to include the entire seller compensation amounts in the purchase price, the down payment would be based on all of it and (most important) the business valuation would have to support the, now increased, total purchase price.
Structuring this transaction today would be different in a few ways. The first would be to determine the new amount of down payment which can possibly including a seller note to reach that required level (as long as it is on full stand by, same as before but based on the new amount). We’ll call this seller financing note # 1 (counts toward down payment). A second seller note will be created for the amount typically agreed to as the “earn out” portion and we’ll call this note # 2. This second note will be classified as “forgivable”. Basically note # 2 will look like every other seller promissory note except for an added clause stating that should the revenues fall below a certain number (typically prior year gross revenue) then a portion of this note is then “forgiven”. This second note is not to be confused with the sellers first note assisting with the down payment requirements, that note cannot be forgivable which is why we structure this as a second seller note. Note # 2 does not have to be tied to revenues and can be created to reflect whatever terms were contemplated in the earn out prevision. As an example, many times I see this note tied to customer base, revenues, or even employee retention to make up for certain concerns a buyer might have on a particular business. Should the company meet the determined criteria moving forward the seller would receive the full amount of the purchase price.
The next concern is the business valuation as these structures are typically used for fast growing companies that might not have valued out based off the last 3 years of historical cash flows. In this instance we will address this concern directly with the valuation company engaged by the lender as required by SBA rules. Items we bring to their attention will be such things as orders in hand to show the current level of increased business, current A/R and A/P schedules, WIP reports and the overall growth of this company. Keep in mind that a valuation company should have more knowledge on these type items than any lender when it comes to valuing this company and once they truly understand the growth potential, it should value out. Business valuations along with addressing them coming in high or low will be another entire writing, so for now we’ll say we were able to secure an acceptable valuation and close the above transaction.
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