If you are a vendor or a purchaser of a business and are struggling to find enough upfront capital for your exit or entry, there are a few options that are available to you that could help bridge this gap. Two popular strategies are vendor finance and earn-outs, both of which can ease the burden of immediate payment while aligning the interests of purchaser and vendor.
Vendor Finance
Vendor finance is an increasingly common tool in business acquisitions, particularly where traditional lending may not be readily available or suitable. It typically involves the vendor lending a portion of the purchase price to the purchaser, secured by an agreed-upon form of security, and repaid over time with interest.
How Vendor Finance Works
In a vendor finance arrangement, the purchaser agrees to pay a portion of the purchase price upfront, with the remainder ‘left in’ or financed by the vendor. This loan is most often secured by the assets of the business being sold through a General Security Agreement (GSA), a mortgage over real property, or a specific security agreement over certain assets. Interest is charged on the financed amount, often at a competitive rate negotiated between the parties, dependent on the level of risk for vendors.
Key Commercial Considerations
While vendor finance can be highly advantageous, there are several important factors to weigh when structuring such an arrangement:
- Default Risk: One of the primary concerns for the vendor is the risk of the purchaser defaulting on repayments. Contracts include provisions where interest rates increase in the event of a default, incentivising timely payments and protecting the vendor’s financial position.
- Security Arrangements: The type and scope of security provided is crucial. Vendors will often secure the loan against the business assets. The vendor will need to consider how they rank against other creditors like banks in terms of security. This is a key consideration when giving vendor finance. Purchasers will likely require external financing through their bank who will have a General Security Agreement which gives them security over all the company’s present and after acquired property. The bank will rank above the Vendor in terms of security when giving vendor finance. However, the vendor can enter into certain agreements with the bank such as a deed of priority to provide protection over the vendor finance payments by the bank agreeing it has no claim to them if the purchaser is not in default to the bank. This gives the vendor confidence that it will receive the payments from the vendor finance arrangement although risk of purchaser default to the vendor and purchaser’s bank still remains.
- Return on Investment: From the vendor’s perspective, vendor finance can enhance their return on the sale. Instead of receiving a lump sum, the vendor receives regular income through interest payments, potentially yielding a better return over time. This can be appealing for vendors looking for steady cashflow post sale.
- Debt Servicing from Business Proceeds: A well-performing acquired business can generate enough revenue to service the vendor finance debt. This can make the transaction more feasible for purchasers who might otherwise lack the upfront capital. To ensure that the business is performing well, it is prudent for purchasers to do their own due diligence on the business. Due diligence is a process of investigation to research and analyse that the business you are acquiring has measurable commercial potential and does not have any hidden financial issues.
- Flexible Repayment Terms: Vendor finance arrangements are often more flexible than traditional bank financing. Repayment schedules can be tailored to suit both parties, offering more adaptable terms and less rigid structures.
- Increased Purchaser Pool: Offering vendor finance can make a business more attractive to a wider range of purchasers, particularly those who may struggle to secure traditional financing. With the increased affordability for purchasers, vendors may be able to command a higher sale price than they would otherwise. While the pool of purchasers is increased by offering vendor finance, it is also important that the vendor feels comfortable with the purchaser and confident in their ability to pay back the loan.
Earn-Out
An earn-outprovision can also provide a practical solution to bridge the gap between a purchaser’s and the vendor’s asking price. This structure allows both parties to move forward with a deal while accounting for their differing valuations, provided it’s carefully negotiated and tightly drafted.
What Is an Earn-Out?
Consider a common scenario: you, the purchaser, believe the business is worth $2 million. I, the vendor, believe it’s worth $2.5 million. Rather than walk away or compromise prematurely, we could agree on a $2 million purchase price, with the potential for an additional $500,000 earn-out, but only if certain performance targets are met after the sale. In most instances, the Vendor’s director/s and key staff continue to work for the business after the sale of the business with the goal of meeting these targets. This is advantageous for both the vendor and Purchaser as the Purchaser gets the benefit of the vendor’s experience and knowledge of the business, while the vendor can potentially earn more of the purchase price if the business performs well.
An earn-out bridges the valuation gap by tying part of the purchase price to the future performance of the business. If agreed-upon financial targets (such as revenue or profit benchmarks) are met, the vendor receives the additional amount. If not, the purchaser avoids overpaying.
Aligning Interests and Managing Tensions
Earn-outs create a natural tension: the vendor, who is often still involved in the business, is motivated to hit short-term performance goals to meet the earn-out goal. Meanwhile, the purchaser may be more focused on long-term strategy and sustainable growth of the business, which may or may not align with the earn-out criteria. Each party needs the extent of its control over matters set out in detail.
This tension makes clear, enforceable agreements essential. A vendor might insist on protections to ensure their role and decision-making power isn’t undermined during the earn-out period. This could include clauses stating:
- The vendor’s employment/contractual relationship can’t be changed or terminated without serious misconduct;
- The purchaser must not make material changes to the business that would interfere with achieving the earn-out targets; and
- The financial metrics used to calculate the earn-out are clearly defined and transparently reported.
Without these safeguards, either party could act in a way that unfairly influences the outcome of the earn-out.
Key Commercial Considerations for Earn-Outs
When well-structured, an earn-out can be a win-win. The vendor gets the opportunity to realise the full value they believe the business is worth, while the purchaser hedges against the risk of overpaying. However, several critical considerations must be addressed:
- Comprehensive Contractual Protection: Earn-out provisions must include protections for both parties, especially the vendor if they are staying on to operate the business. This includes restrictions on dismissal, restructuring, or other actions that could impact business performance during the earn-out period.
- Realistic Targets: Targets should reflect the actual earning capacity of the business. Unrealistic goals can turn an earn-out into a point of conflict or disappointment. The earn-out should complement the deal and should not become its focal point.
- Target Structure: Earn-out targets can be structured in multiple ways. It could be structured so that if the target is reached, you get the entire earn-out or if you miss it, you get nothing. Alternatively, it could be structured pro rata, to include extra bonuses if certain targets are exceeded.
- Timeframe: The earn-out period must be long enough to realistically assess performance, but short enough to keep both parties engaged. Typical earn-outs can range from 12 to 24 months, depending on the size and complexity of the transaction.
- Key Team Members: If there are key team members that are needed for optimal operation of the business, the vendor could consider contracting to restrict the dismissal of key staff members.
- Short-Term vs Long-Term Strategy: Earn-outs can inadvertently encourage the vendor to prioritise immediate revenue or margin growth, potentially at the expense of the business’s long-term health. Purchasers need to be wary of this and ensure the metrics chosen don’t incentivise harmful business practices.
- Alignment of Interests: Successful earn-outs depend on aligned incentives. The vendor will want to maximise the business’s performance for the earn-out period, while the purchaser needs the flexibility to manage the business strategically. Open communication and fair contract terms are key to balancing these goals.
- Dispute Resolution: It is important to have clear guidelines for both parties to resolve disputes quickly and efficiently. By including provisions to engage in good faith negotiations and/or mediation can help curb the escalation of issues and stop it from impacting the operation of the business. Disputes that cannot be resolved between the parties are often referred to independent accountants as well.
Summary
Earn-outs can be an effective way to bridge valuation gaps in business sales, provided the structure is fair, the goals are realistic, and both parties are committed to transparent and collaborative operations during the earn-out period. With the right legal and commercial advice, an earn-out can turn a deal stalemate into a strategic win for both sides.
Both pricing structures can become very complex when the vendor and purchaser start to negotiate. We have extensive experience in negotiating and advocating for both vendors and purchaser to create workable and practical solutions in purchasing a business. If you are considering selling or purchasing a business, please contact our commercial and corporate expert Sarah Churstain.