Earnout or Seller Financing: Which is better for your business sale?

  • By Bob Hughes
  • 15 Jun, 2015
When structuring a business sale, a common problem that arises is a difference in opinion on the value of the business. It's important to recognize that the two parties are motivated by different information. Buyers are focused on past earnings and the operational risk in the business that will affect future earnings. Sellers typically focus on the company's recent historical performance, hoping to maximize their profit from the sale.

This difference in focus can make it difficult for either side to find balance between the amount that a buyer is willing to pay and the amount a seller is willing to accept. An earnout or seller financing can bridge the value gap, yet each has its own pitfalls and advantages.

Of course, an all cash deal at full market price would be a dream for any seller, but the reality is that these two innovative financing solutions are often the magic that makes many business acquisitions happen. Read on to determine which financing solution is best suited for you and your business.

Seller financing
Seller financing is when the seller agrees to finance a portion of the purchase price over a set period of time. The amount due in the future is defined and capped, limiting the upside, but protecting the seller's interests by establishing a repayment schedule.

This option is best suited for a departing owner that wants the security of a guaranteed repayment schedule.

Businesses with steady sales and operating profits are a good fit for this type of acquisition financing solution. By offering this repayment option to a buyer, it widens the buyer market, increasing the chances of multiple offers and a higher selling price.

When there is a shortage of bank financing or the need for multiple financing options, this is when seller financing is vital. Buyers are increasingly asking sellers to finance a portion of the purchase price as a means of bridging the value gap. The buyer has to come up with a portion of the total price up front and the remainder over time. It is typical for a seller to finance one-third to two-thirds of the sale price within a three to five year term.

Here is a look at some of the benefits and risks associated with seller financing.
Benefits:

A seller has access to the full purchase price, which might otherwise not be possible.

Businesses typically sell for 15% more when seller financing is provided.

Sellers can earn 8-15% interest over a five to seven year period, resulting in increased compensation from the sale.

Security over non-business assets can be requested to guarantee repayment.

Bank financing options are more likely with an increased amount of equity in the deal.

Risks:

Success under new ownership is not guaranteed and the seller will have money at risk.

Finding the right buyer that has the appropriate skills to take over the business is important.

A buyer may be unable to make the scheduled payments. A carefully crafted agreement can protect the seller's interests in this worst-case scenario.

The bottom line:
This creative financing solution may be the best fit for you and your business if you wish to successfully sell your business and its goodwill. Acquiring lender financing for goodwill can be tricky, but if designed correctly, this option increases the probability of lender financing.

Earnouts
An earnout is where a portion of the purchase price is paid after the closing, contingent in whole or in part on the target company's financial performance over a specified period of time. Earnouts are common in about 80% of acquisitions and typically represent about one-third of the total transaction value. They are typically based on the projections that the seller prepares as part of the sale and/or due diligence process. Earnouts are structured as a percentage of a mutually agreed upon financial metric.

Earnouts are typically suited for high growth businesses where future financial results are difficult to model.

Despite having a compelling reason to sell the high growth business (which is key), the owner has a firm belief in the company's future potential. As such, they are willing to take on the risk that it will perform to its expectations, even under new ownership. Earnouts make the buyer believe in the future of the business.

Benefits:
No limit to seller profit.

No increase in buyer risk.

Helps protect a buyer from overpaying for a business. If a milestone is missed, the additional consideration is not paid.

Protects a seller from selling too cheaply. If the business continues to perform well and milestones are achieved, the seller gets additional compensation over time.


Risks:

Earn outs are often more complicated and risky to the seller than seller financing, as future payments are not guaranteed or collateralized.

Earnout negotiation points:
Unique to the structure of each earnout is the selection of a target metric, which is typically revenue, EBITDA, or gross profit. Each represents varying levels of risk to each party in the transaction and as such, this determining metric must be wholeheartedly agreed to by both seller and buyer.

Revenue is the easiest metric to measure and the most difficult to manipulate from a seller point of view. Buyers are hesitant to offer this metric, as it doesn't account for whether the revenues are non-recurring or if margins are acceptable. This option is best suited to a buyer who is in complete control of operations after the transition; that way they can control the margin and overhead costs of the business. Sellers typically prefer this metric as it removes the risk of poor management by the buyer.

EBITDA is a commonly used metric for earn outs. A buyer may prefer this metric because it shares remaining profit and corresponds closely to real world cash flow success. On the other hand, a seller may be focused on growing the sales and therefore have preference for a revenue or gross profit threshold. The potential risk associated with this metric is that it is the easiest to manipulate. The "E" (earnings) could be padded with expenses that the seller may not have incurred while running the business. To reduce this risk, unique clauses can be devised to protect a client from expense manipulation.

Gross Profit is often referred to as the "compromise" metric because it's not as easy to manipulate with general expenses. This approach is more appropriate for businesses with stable overhead levels. As long as it is the accurate gross profit of the operation, both parties' interests should be protected.

The bottom line:
The most important takeaway is that precise and careful drafting of the earnout clause is key to minimizing and eliminating disputes. With the right guidance from experienced advisors, the earnout should be viewed as a powerful tool in price negotiation. Although seemingly
By Loren Marc Schmerler is President and Founder of Bottom Line Management, Inc., IBBA Member 12 Jan, 2018
1. How much is my business worth? The correct answer is the price a Buyer offers you that you are willing to accept. It makes no difference whether you are making money or losing money. It makes no difference whether sales are increasing, declining or flat. It makes no difference how much blood, sweat and tears you have put into your business. It makes no difference how much money you have invested in the business. It makes no difference how much money you owe to the bank or to yourself.

It makes no difference what a business valuation or appraisal says. It makes no difference what your hard assets are. It makes no difference what your customer list or client list contains. It makes no difference what your patents or service marks cost you. It makes no difference whether you are a Franchiser, Franchisee, Licensor, Licensee, Distributor or Independent Contractor. The bottom line is that what you finally accept is what your business is worth.

2. How long will it take to sell my business? The correct answer is no one knows for sure. But I tell my clients that the average time is seven months from listing to closing. For companies that sell for $1 million or more, the average is nine to twelve months. But I also explain that the quickest I ever sold a business was one week, and the longest it ever took me to sell a business was six years. Additionally, I explain that price and terms sell a business. The lower the price the more affordable the business will be. The lower the down payment, the more people will be able to consider it. The greater the amount of owner financing, the easier the business will be to sell.

3. Is there anything I can do to make my business more desirable? The answer is yes. The most important thing you can do is to put your ego aside and not make the business dependent upon you. Ideally, the goodwill of the business should be at the lowest level that interfaces with customers or clients. This means that you want to hire and keep employees that make your customers happy with high quality work and excellent customer service.

4. Is there anything I should not due during the listing period? The answer is that you should not slack off in any way. You need to stay focused and operate your business as if it will never sell. You need to work as hard or harder no matter how burned out you feel. Do not make any major changes during the listing period. Try to retain all good and excellent employees and remove those that are not contributing as they should. Try to keep your inventory fresh and eliminate any obsolete items. Keep your equipment and machinery well maintained and properly functioning.

5. What is due diligence? It is the process where the Buyer examines all your books and records, gets approved by the Landlord, gets approved (if applicable) by the Franchiser, Licenser, Distributor, bank, etc. Your books and records need to be current and “bullet proof.” Your tax returns for payroll taxes, sales tax, state income tax, federal income tax, county income tax, city income tax and any other municipality taxes are 100% current. Your various licenses need to be current whether or not the buyer will have to apply for their own. You want to fully disclose everything and not leave any skeletons in the closet.

6. What else do you suggest I do to impress a Buyer? Have a job description for each employee. Put together a Policies and Procedures Manual. This will make the corporate buyer feel more comfortable about taking over the reins. Make sure all your employee reviews are current. The last thing a new owner wants to do is to sit down in a vacuum with an employee who is expecting a raise. Make sure you clean everything that is dirty. Make sure you fix anything that is broken. You do not want the Buyer to wonder what else might be a potential problem. Prepare a business plan and/or marketing plan to show the Buyer how he or she can grow the business. Put together a transition plan that shows the Buyer how you will assist them daily for a period of 28 days. The Buyer may not want you for the full transition period, but at least you are showing that you have thought it through and are willing to make yourself available.

7. What happens if I agree to do some owner financing and the Buyer misses a payment? The way the closing attorney prepares the paperwork, if a Buyer misses a rent payment or a note payment, it is considered an event of default under the note. This will allow you to take back the business in a worst-case scenario or enter into serious discussions to protect your financial interests. While the best outcome is a Seller getting paid all their money and a Buyer being successful, you must plan for the worst and hope for the best. But I also tell my clients that they should never sell their business to a person they feel will not treat their employees, customers, clients or vendors properly. If you ever get a knot in your stomach during the negotiation that is the time to throw in the towel and let me gently explain to the Buyer that you do not feel it is a good fit.
By Jonathan Funk 23 Aug, 2017
On July 18th 2017, The Federal Government announced major tax changes on business owners - triple taxation.
Previously you would have received much more on the sale of the share or assets of your company.
The new legislation taxes could be as high as 75%.

Astra has a proven program that will mitigate this new onerous tax legislation. We would like to have the opportunity to show you how we can do that. To avoid “triple taxation” you must plan your exit strategy through a proven program. Our SuperMax and MiniMax programs will abate these new punishing tax changes. Our financial consultant will review your situation and demonstrate how Astra’s Super or Mini Max programs will work for you to save you many, many thousands. Please contact us at info@abc-astra.com or bhughes@abc-astra.com.


SUMMARY

This note is a summary and clarification of the 27 page announcement by the Minister of Finance on July 18 which has major implications for private business owners in Canada. Please take the time to review this note and give yourself time for reflection. We suggest you read this more than once.

The tax consequences of the NEW Rules could cost you millions of dollars without putting smart tax planning in place.

Scenario A - Under the old rules, you could sell your company’s shares and after it paid the capital gains taxes due, the net cash proceeds could be put into your hands personally with no additional tax to pay on the transaction. Not any more.

The proposed new rules should not impact your company 's ability to pay capital dividends (net after tax proceeds from the sale) to you as a shareholder unless the buyer and the seller are not dealing at arm's length (for example, between family members). With a non arm’s length transaction, the net proceeds are taxed again in your hands as an ineligible dividend at an effective tax rate of between 42 to 57% depending on your province of residence.

Scenario B - Under the old rules, you could sell your company’s assets and after it paid the capital gains taxes due (if any), the net cash proceeds could sent to your Holdco as an after tax intercorporate dividend with no additional tax to pay on the transaction. This would have allowed yo to redeploy cash for other investments. Not any more.        

The proposed new NEW Rules will disallow the inter-corporate dividend as a tax free transfer to your holdco and instead tax it as an ineligible dividend at highest possible tax rates.

Scenario C - Old rules: Shareholder dies, creating a deemed disposition of shares. No tax paid liquidity is in hands of estate to pay tax. Estate uses a capital loss manoeuvre in combination with “stop-loss” rules and acceptance of a promissory note from a corporation to mitigate the amount of actual tax due as a result of deemed disposition of shares when the shareholder dies.

The proposed new NEW Rules will disallow the estate from transferring shares with a high cost base to a parent company in exchange for a tax-free promissory note.    

NEW Rules : Shareholder dies, creating a deemed disposition (CRA considers shares and other personal property to be disposed/sold) of shares. No tax paid liquidity (ready cash (on hand) is in hands of estate to pay tax. Estate raises cash to pay this tax by selling corporate assets with attending cap gains tax "A". Net proceeds are paid off of the balance sheet to pay the cap gains tax on the deemed disposition caused by shareholder's death. This is Tax "B". However since it all came off the balance sheet, CRA wants additional tax as they regard this as a non-eligible dividend or Tax "C". This is "triple taxation". A+B+C=CRA The total tax bill could be as much as 75%!!!

Scenario D- Old and New rules are the same: Shareholder dies, creating a deemed disposition of shares. No tax paid liquidity is in hands of estate to pay tax. However life insurance proceeds come into and out of the corporation tax free by way of capital dividend account (CDA. Sec. 89) to pay required taxes. Estate now transfers shares to whomever it is directed by the Will of the deceased shareholder. No corp assets were sold, no taxable cash came off the balance sheet's current assets yet the cap gains tax were paid. The new shareholder's capital is still on the balance sheet but it is now tax paid or paid up capital (PUC). Dividend income paid at say 8-10% of the tax paid PUC are within CRA's "safe income" rules but taxed at the attending marginal rate.

Here are the main reasons tax practitioner’s advocate the use of life insurance in corporate-estate situations: A) it’s a lot cheaper than paying ANY amount of tax and B) it is already pre-approved by CRA and does not cause any tax burdens.

In summary: either from action or inaction when large blocks of capital are moved into the hands of a shareholder or an estate, the transactions are on CRA’s maximum tax radar. On the other hand if dividend income on capital is employed as a source of income, the tax rates are far less than taxes on salary or high amounts of capital treted as ineligible dividends.

In Brief, CRA does not want you to take capital off a balance sheet, but keep it employed ON the balance sheet, and CRA is satisfied.

Therefore smart planning will open doors for tax efficient succession planning for your family and provides options to negate asset sales triggering double or even triple taxation.
And, smart planning utilizes the Income Tax Act’s rules to get your hard earned capital into shareholders hands while you're alive either tax free or with a lot less tax paid during your lifetime and after death.

Bottom Line: Smart Planning will get you:
  • a strong balance sheet 
  • a company that will not be hurt or destroyed because of tax
  • happy shareholders 
  • a happy estate
  • satisfied CRA
  • Everybody wins!

Smart planning starts with us. Contact us now.

TIME IS NOT YOUR FRIEND – WE HAVE WAYS TO HELP
By Robert Hughes, Astra Business Corporation President 22 Jan, 2016

Astra, with their associates, have developed exit strategies using major banks and insurance companies to transfer ownership of your company in a manner similar to a department store ‘lay-a-way’ plan. There are two programs to choose from - MiniMax and SuperMax.

These programs offer a customized succession plans, which enable business owners to hand the reins of their business to a new generation or investor, while securing a TAX FREE retirement income stream, reducing risk, eliminating volatility and creating an estate legacy.

This is a strategy that has a stated time frame to transition the operation, and eventually, the ownership of the business. This succession plan maximizes the net cash flows for the remaining lives of the owner and spouse and if possible, creates a legacy for the surviving family members or investors.

Whereas you are looking to obtain a sale price of up to 4 to 5 times multiple, buyers have been reluctant to provide you with an acceptable purchase price with terms satisfactory to you. These alternate programs will provide you with an acceptable exit strategy with a financial benefit of  many times over what you had originally wanted  and while you are young enough to enjoy your retirement income.

I trust this is of interest. If so please advise and we will introduce you to our associate and start the process with a conference call where an in-depth detailed discussion will reveal how this program works.

Looking forward to working with you.

Click here for more information.

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