Business owners who sell their companies often end up regretting their transaction. PriceWaterhouseCoopers conducted a survey with business owners who had previously exited. The results of their survey proved that 12 months after selling, 3 out of 4 business owners surveyed “profoundly regretted” the decision to sell. This Wire delves into a major reason for the regret: contingency payments, which typically heavily favor the buyer. Most buyers do not want to pay cash or stock for 100% of the purchase price, but instead require that a portion of the payment is contingent upon the company under new leadership meeting the mileposts set by the old leadership.
Contingency Structures Increase the Likelihood of a Deal Closing
Approximately half of all acquisition transactions with a purchase price between $10MM to $25MM include seller financing and/or an earnout, whereas this share is smaller, though still significant, for higher value transactions: about one-third in transactions with a purchase price from $25MM – $50MM and about a quarter of deals $50MM – $250MM. These so-called contingency payments increase the number of deals that get closed a year. Without them, the gap between the seller’s valuation expectation and that of the buyer, and second, the buyer’s lack of willingness to pay 100% of the purchase price in either cash or stock, would cause a significant number of deals never to close. So contingency structures increase the likelihood that a deal closes.
Types of Contingency Structures
An earnout structure establishes future consideration payments to be made to the seller if certain revenue or profit benchmarks are achieved. When the seller markets their company to buyers, they often include a forecast, which the buyer believes to be overly optimistic. When the buyer comes up short in what they are willing to pay the seller in cash and/or stock, the gap in purchase price needs to be filled unless the seller lowers their expectations. Earnouts is one way to do this. They are often 2 to 4 years in duration. Another way is by using a seller note. Unlike an earnout, the seller note is paid, regardless of performance. With seller notes, the buyer “finances” part of the purchase price with the seller taking a note for some portion of the payout instead of cash or stock. The buyer pays interest and the principal payments are often structured for 2 to 5 years in duration.
Contingency Payments Not Likely to Materialize
Unfortunately, from the seller’s point of view, contingency payments are frequently not paid to the seller. Even seller notes, while not tied to performance may well end up not being paid if the notes become subordinated to senior bank debt used to finance the day to day operations of the business. Over a short period after the transaction, the seller note becomes less of a priority as buyers need to keep a capital reserve for higher priority needs to execute the business strategy. Earnouts are even less likely to be paid out if they are tied to lofty seller projections. The seller loses their influence on the ability to execute the strategy once the buyer takes over, and while the buyer may be genuinely hoping to fulfill the earnout, often buyers fail to achieve integration and ROI goals themselves, and the earnouts never materialize.
Industry Shortcoming – Bankers Get Paid on Full Value
This lost value is a large reason why so many sellers report that they “profoundly regretted” their decision to sell their company. Whether earnouts never materialize or the seller note gets deeply subordinated, or for various other reasons, a seller’s best day is unfortunately far too often at the closing table. The buyer is fortunate because they purchase the company for less than full value. The investment banker is also fortunate, because their success fee is based on the full purchase price, as if all seller notes are fulfilled and the entire earnout is earned by the seller. The success fee is paid to the investment banker at the closing table. Therefore, often, the deal team that helps you “reach the altar” has no incentive or even services to help their client ensure that the full purchase price for which they worked hard ever truly materializes.
Seller Loses Influence and Cannot Help Buyer through Integration
Once a company is sold, the buyer often phases out the influence of the previous owner and the leadership that previously prevailed. The projections that the seller fought to convince the buyer were achievable were tied to the seller’s strategy. However, the buyer often executes a different strategy and therefore the projections become stale with time. Further, the buyer often struggles to achieve integration goals themselves, due to many reasons. As integration unfolds, the owner can become detached as they slowly lose influence. For these reasons, the contingency payments become at risk.
How to Solve This Issue
It is a problem that no one except the seller is motivated to see the contingency payment fully realized—since even their partner in the transaction, the investment banker, also gets their full payment regardless of whether the seller ends up getting their full contingency payment or not. One possible solution would be to change the role that investment bankers play, and offer services to sellers to increase their chances of capturing contingency payments. Additionally, investment bankers could structure deals with contingency payments in ways that would be more likely to favor the seller, including aligning the investment banker’s success fee with the overall success of the transaction for the seller (however defined). However, there is also validity to the argument that the investment banker’s fee should not be dependent on how well the buyer achieves its goals post-transaction. Further, it is traditionally at the conclusion of the transaction that the investment banker’s services are complete, especially if their client is the seller. And typically, investment banks are not integration specialists anyway.
Another solution is for the earnout to be set as a percent of sales or profits, rather than an all or nothing scenario for the years the earnout is measured. Earnouts could be more event driven where the seller maintains influence over that event’s outcome. For example, if projected revenue growth is tied to the launch of a new product or service initially developed by the seller, or winning a significant client that the seller had teed up, then some contingency payment could be made to the seller.
Watermark is tackling the problem of seller’s loss through contingencies by offering integration coaching to the seller before and after the transaction occurs. Helping the seller better understand what it will take to achieve performance based contingencies, for example, Watermark thereby positions the seller to negotiate more successfully and to ensure a better outcome for the company. Overall, this will put the seller in a better position to establish a win-win relationship with the buyer, which hopefully results in better statistics in also ultimately receiving the earnouts or seller note.