When you sell your company, the likelihood of an all-cash sale paid at the close of escrow is not high. The greater likelihood is that the sale proceeds will include some of the following financing methods:
- Cash from the buyer’s own resources
- Cash from external financing
- “Straight” note that you carry
- “Adjustable” note that you carry
- Earn-out
The “straight” note will be a fixed principal promissory note that carries some rate of interest.
The “adjustable” note is not a note with varying interest (such as an adjustable mortgage). Instead, the “adjustable” note is a note whose principal amount will reset – typically once – at an agreed point in time based on some metric of the company (often revenue). For example, the note has an initial principal amount of $10 million. On the first anniversary of the sale, the principal amount is adjusted up or down by the percentage change in your firm’s gross revenues. If sales go up 10%, the note’s principal amount is adjusted to $11 million going forward. If sales go down 10%, the note’s principal amount is adjusted to $9 million going forward. After the adjustment, it is just like a "straight" note.
An earn-out extends the concept of the adjustable note. Typically, the earn-out is framed in terms of a multiple of a particular company metric to be paid over a period of time. For example, the buyer pays the seller 25% of revenue for the next four years – with pro rata payments made each calendar quarter. If revenues ramp up or down, so do your payments. In the case of an earn-out, the seller has a huge incentive to see that the company is successful post-sale.
In the case of a cash payment and external financing, the risk of future performance of your firm rests with the buyer. This is the case whether the buyer’s cash is coming from the buyer’s own resources or external financing. When you extend financing to the buyer, you are assuming some of the risk. In the case of the straight note, the dollar amount you ultimately receive does not vary . . . unless the buyer becomes insolvent. Which would likely be the result of imploding your baby.
However, when you use an adjustable note or an earn-out, you are taking on additional risk regarding the post-sale performance of your firm. Why would you want to do such a thing? Typically, when a seller retains some level of post-sale risk, that risk needs to be compensated. Phrased another way, you get a higher selling price. Another reason why a seller might extend these forms of financing is because the buyer doesn’t have the resources and can’t find external financing. This is common with junior partner buy-outs.
The takeaway is that there are some financing scenarios in which the seller has a vested interest in the company’s post-sale success. We have set the stage. In the next articles in this series, we will call upon industry experts to discuss how you might build post-sale success into your company. And, that success might translate into higher net proceeds from the sale of your company.
For a free PDF copy of my book about tax savings when selling your business, please email me at todd@integratedwealth.com.
