There are various ways buyers and sellers can bridge valuation gaps to reach an agreement on purchase price in an M&A transaction. These include earnouts, seller notes, and rollover equity.
What is an earnout in M&A?
An earnout allows the seller of a company to receive additional purchase price value following closing if the business sold achieves certain financial performance milestones (usually based on revenue and/or EBITDA targets). They are often used to address purchase price valuation gaps. According to SRS Acquiom, the use of earnouts increased by approximately 62% in 2023, which suggests growing purchase price valuation gaps between buyers and sellers during that period. In addition, in 2023, the portion of a purchase price captured in earnouts hit an all-time high of 40%.
In an earnout scenario, be prepared to address:
- Subordination of the earnout to post-closing debt;
- Dispute resolution mechanisms to determine if the financial performance milestones are achieved; and
- Business operational covenants imposed on a buyer during the earnout period following closing.
The milestones for an earnout can be one or a combination of targets, such as EBITDA, revenue or gross profit, or certain non-financial targets, such as selling a certain number of products or obtaining a specific regulatory approval.
The time period to receive an earnout after closing can range from one to five years, with two years being the most common time frame utilized.
The payment terms for earnouts can be structured in a variety of ways, including payments in installments over certain time periods, payments in one lump sum, and an all-or-nothing or sliding scale approach.
What is a seller note when you buy or sell a business?
A seller note is a form of financing provided by a seller to a buyer, typically unsecured, which allows the buyer to pay a portion of the purchase price (typically 10% to 20% of enterprise value) through one or more debt payments following the closing.
When utilizing a seller note, be prepared to address:
- Interest rate (typically 6% to 8%);
- Timing of payment for principal and interest; and
- Events of default and other acceleration events (e.g., change of control).
How is rollover equity used in a business purchase or sale?
Rollover equity allows the buyer to pay a portion of the purchase price by issuing equity to the seller in the buyer entity or an affiliate of the buyer. Rollover equity allows the seller to participate in the future upside value of the business and have a potential “second bite at the apple.”
When dealing with rollover equity, be prepared to address:
- Whether the seller will get a board seat;
- Minority protections for seller, such as veto rights over certain key actions (e.g., affiliate transactions); and
- Where the rollover equity receives distributions in the waterfall.