When selling your business for the first time, there are common assumptions business owners make. One of those assumptions is that the deal will close in all cash and quickly. While this is an option, and it does happen, it may not be favorable for the buyer or the seller. It also may not be the deal on the table. Let me explain.
When using one of the methods below to sell a business, there is a win/win situation for both seller and buyer. The buyer may reduce their overall risk based on the deal terms, and the seller can negotiate a price and deal structure that is greater than if they just sold their business with an all-cash deal. Here are the 3 common deal structures:
#1 Deal Structure: Earnout
An Earnout structure is a type of deal structure where the purchase price is contingent on the company hitting certain financial benchmarks after the deal closes. For example, the seller may negotiate the following deal terms: they get 75% of the sales proceeds in cash up front at the time of close, and the remaining 25% comes from the company hitting those financial benchmarks agreed upon. The earnout, like it sounds, is “earned out” over time, with typical terms in the two-to-five-year range. Savvy negotiators will ensure that the earnout, if achieved, brings in more cash to the seller than an all-cash deal. This creates a win/win for the buyer and seller.
There are two major parts of the business purchase agreement that will need to be documented and approved to govern the terms of the earnout deal structure. The first is the length of period the financial benchmarks are based upon, and the second is who in the seller’s management needs to stay on to ensure those benchmarks are achieved. In most deals, this will be the owner, the owner and member(s) of the management team, or a key manager. An earnout deal structure eliminates uncertainty for the buyer and allows for the seller to capitalize on the future growth of the business.
With that said, owners are not used to having a boss – they’re entrepreneurs at heart – and they are not 100% in control of their destiny after the sale. So, as in any deal, care must be taken to evaluate the earnout terms and ensure as the seller this is something that is achievable and ultimately lucrative.
#2 Deal Structure: Noncompete
It happens all the time – the seller gets an idea for another business that’s very close to his or her current business model. It may even be a new spin on their same business model. In other words, when they sell, they immediately become a competitor to their own business. What buyer would agree to that? You’d be surprised, but the reality is the buyer will want protections put in place in the purchase agreement to prevent this very thing from happening. Now, of course, there are time and regional restrictions that govern non-compete arrangements, just like you see in employment agreements.
If you’re savvy, and you have a great M&A advisor or business broker, you can negotiate a higher purchase price with the buyer if you can agree not to compete with the acquirer. This makes sense, and it’s the same arrangements set up when an employer sets up the terms of an employment agreement.
The buyer is asking for assurance that when they purchase the business, the seller does not go and create another similar business and start competing with their former business immediately. Of course, as with most non-compete covenants in general, these covenants can only be enforced for a limited time and within a specific geographic area.
#3 Deal Structure: Installment Sales with a Seller’s Note
Installment sales with a seller’s note are a very common deal structure for a seller to get a higher purchase amount. A deal like this could look like 75% cash up front, and 25% covered in a seller’s note that is paid to the seller over time. The buyer will use after-tax cash flows from the acquired business to pay off the seller’s note, which usually has a term-length of two to five years. This allows the seller to have more options for buyers, as all buyers may not have the cash to buy the business outright. This also allows the seller to earn a reasonable amount of interest over the payback period.
In that way, this type of deal structure creates a win/win for the buyer and the seller – the buyer does not have to shell out 100% of the purchase amount in cash up front, and the seller gets a higher purchase amount by taking on the additional risk by financing part of the deal. The key is seller flexibility. The seller provides a new way for the buyer to acquire the business, inspiring that next generation of business owners and, in effect, helping secure that legacy for their business.
Regardless, it’s important to exercise caution when executing a deal like this. For instance, the business needs to stay profitable over the term-length to pay off the seller’s note.
Final Thoughts on Deal Structures
While taking cash is never a bad thing, there are multiple types of deal structures that a seller can leverage to achieve a higher sale price for their business. All these types of deals take a certain level of cash off the table, usually more than 50%. They also incorporate different negotiating strategies and deal terms to maximize value for the seller and simultaneously reduce risk for the buyer. By using a combination of cash up front and leveraging one of these deal structures, sellers leverage strategies that can potentially lower their initial tax burden at the time of sale and defer remaining taxes as the additional proceeds are earned over time.