Seller Notes and Earnouts

[Music] hey guys welcome to another edition of inside the exit I'm your host drew Brantley joined today by Bob fresh welcome to the show thanks q guys today we're talking about earn outs and seller notes so when you're selling a company you know most sellers you want to get the most for your company that you can or you have a number in mind or you want to push people to try to give you more money at the end of the day sometimes when you're selling a company there's a there's a gap between what you believe is the right number for the company and what a buyer is willing to sell and oftentimes earn outs and seller notes are financial tools that are able to kind of bridge that gap in valuation it's basically a way for you to get more money for your company but you don't get it at the close you know when the wires when the wires flow sometimes it means these amounts are going to get paid out over multiple years or a five-year period or two years or whatever it is so let's talk a little bit about what a turnout is and what a seller note is and then a few details around kind of what you can expect now a seller note is is a debt piece of paper uh it's just kind of like a loan from a bank almost and a seller note is a guaranteed amount that you're gonna get over a period of time a lot of times we see seller notes that have kind of five or six year terms to them you're allowed to put you know kind of a normal interest rate on there of you know five six seven eight ten percent whatever it is that you agree to for that seller note sometimes they have a current interest payment sometimes they have what's called a pick or payment in kind and a payment in kind is basically a way where let's say you have a seller note that's a hundred thousand dollars and basically let's say it's ten percent for easy numbers and let's say it's a 10 percent pick then that means that every year they're going to add 10 percent of the value of the principal which is that hundred thousand dollars to the principal so at the end of year one the principal or the amount of that note or that debt it's gonna go from $100,000 to 110,000 dollars so then in year two all of a sudden your pick or your payment and cotton is going to accrue at that same ten percent but it's going to be accruing off that hundred and ten thousand dollars not the hundred thousand dollars so some different ways that you can can structure that one of the really important things to know about a seller note is that if you have a seller note as a part of your structure and the buyer is intending to put future debt on the business whether it's you know senior debt from banker or mezzanine or subordinated debt you're gonna need to expect that your seller note is going to be subordinated to the other lenders in the deal basically from a bank or a lender's perspective they're gonna want to know that they're gonna get their money before you get your money now some of you might be saying wait a minute that's not fair why not why can't I get paid in a banks mind you're already getting some money or they're assuming that you're getting some money off the table in the sale so let's say in that example you sell your company for a million dollars and you're a hundred thousand of that it's gonna roll over kind of in a excuse me not roll over but it's going to be in US in the form of a seller note so you're getting nine hundred thousand dollars off the table you've already gotten some money off the table you just put some money in your in your pocket well the bank's gonna say look you've already gotten some money we're gonna want to come out in a first position ahead of you so you're gonna need to be subordinated to that lender so oftentimes it's okay to get your interest back on that note but you can talk about having some amortization meaning getting some of that principal back ahead of that five or six year time period or whatever your term is but expect that if another lender comes in you might need to stop that amortization or not get any principal back for a period of time so a lot of ways that this can get structured but hopefully this gives you a sense about it Bob yeah seller notes are something that often times put put into a transaction you're selling your company and as Drew pointed out there's a difference between what you want and what the other group is offering or there's a difference in the amount of financing that's going on in place but for whatever reason you as the seller decide I know my company I like my company I know they can pay me some debt if I put some debt on the books so I'm willing to take back a seller note I'll take exit closing in terms of cash and clothes but I'll also take a seller note that helps the buyer buy and it frankly to you you know that note is probably good because you've lived with the company it's your company you do get interest on that note every year but you do have to understand that if there is a bank involved in the deal and mainly is senior lender whether that be a bank or any other senior lender that person at the top were the first lien on everything then that lender is almost undoubtedly gonna want the amortization your payment of principal back that is the amortization is going to be after they get their money out so you get your interest for that maybe five-year period but that Bank gets paid out first and then the seller note we often see people structure things where on the buyer side where they're actually letting the seller note get paid out before the senior bank and what happens is that's almost a surefire way of killing the deal so the sellers as we represent them they have to understand once they enter into a seller note that they're not going to be paid out early for that seller note that it's going to be after the senior bank yeah you can put that in in the LOI or the terms of the structure but just realizes as we've said now twice if there's another lender in there you're gonna need to be prepared to subordinate to them it's just kind of the way it works now let's talk about urn ounce so seller notes are again it's a it's a debt you're basically guaranteed that amount assuming the whole company doesn't blow up at the end of the day or go south but an urn out is a little bit different an urn out is typically something that's put in place where you say your company's going to do X over the next couple of years and basically the buyers saying okay put your money where your mouth is we'll pay you more for the company but we're gonna pay it in the firm for form of an urn out and an urn out very simply is it's a perform it's based payment that based off you hitting certain numbers you're gonna get paid an additional amount now earn outs can get structured in all different types of ways there's not a right or a wrong way to structure an earn out but in general you know a lot of times what we see some consistent things that we see or earn outs typically buyers want to see earn out structured in a way where the the eBay da or the performance of the company is in an upward trend a lot of times buyers don't like to pay earn outs you know if the company is not performing so for example you know let's say your company let's say you're doing 5-minute even dive this year and you say you're gonna do 6 next year well if the company comes in and they do you they do for next year then they're not gonna want to pay you because the company's not doing the six that you said it was going to do especially if you're still involved in the company you know if you're not involved earn outs can be a little bit more of a tricky animal but especially if you're staying involved you're running the company you know people are going to want to see the company continue to perform to be able to hit those so a lot of times again earn outs are put in place where you say look I know my company's going to do XYZ they say great we're gonna pay for it but we're gonna delay that payment until that performance happens so you know sometimes we have people that say oh I'm scared by an earn out you know I'm not going to get paid that earn out doesn't mean you're not going to get paid but just beware that if you're saying all this great stuffs gonna happen be prepared they might want to delay some of that payment for the sale of the company in the form of an ernet yeah it's absolutely true burnouts are based on performance no doubt about it and how you structure it whether it's beyond revenue or EBIT dollar however you structure and earn out many many ways many many ways to structure it a seller note on the other hand is a guaranteed payment of a debt instrument that you have structured into the deal and no matter what the performance as long as the company doesn't go bankrupt you're going to get paid in a certain amount of time that amount of money and you're going to get interest each year Murnau it's not that situation earn-out means that performance is there you show us the performance and we'll pay you more money absolutely one of the things to be aware of you know I we've talked to sellers in the past and buyers for that matter and and and sometimes they get a little ahead of themselves on on the earn-out and they'll structure and earn out in a way to where let's say the company's doing you know three million dollars of Ibadan and then they structure and earn out where they're gonna pay the seller you the seller they're gonna pay you three million dollars in an urn out the second year after you hit that number that's not always the way buyers like to do it because at the end of the day they're basically saying we're giving away everything the company is making so if there's any debt on the company you know they're not going to be able to pay the debt there are going to be able to pay taxes out of the cash flow the business they're gonna need to finance that earn out in some other via some other debt instrument or through some lender or additional equity that they're putting in or something like that so you know just be aware that you know an earn out typically is not going to be don't expect to get the full EBIT die or cash flow of the business in a given year you know if you're wanting a lot more than they're wanting to pay expect that to be doled out over a period of time especially if they're if the buyer is going to plan to put some debt on the business they're going to need to service that debt they're gonna need to maintain a certain amount of cash in the business you know to be able to do what they do and so a lot of times don't want to spread that out over a multi-year period and that's okay again as long as you know you and they feel that it's it's an appropriate thing to do yeah absolutely and the earn out look at it this way the earn out is they say you may hit it but we want you to share that risk we're willing to pay it but you're gonna share in that risk cuz we don't know you you're the seller you know your company better than we do perhaps if you hit it we're happy to pay this amount whatever is agreed to and how it's agreed to but if you don't hit it then we don't we don't have to pay you and that's the way it are now it works so it's a sharing of the risk but it also allows the seller to get to a certain price that he's much happier with knowing future performances on the way well guys thanks for watching this edition of inside the exit today we hit hashed out a little bit of the detail around earn outs and seller notes hopefully you found this to be helpful check out our other videos hit subscribe below and we'll see you in the next video thanks for watching guys thanks [Music]