In an ideal world, buying or selling a business would be easy.
A business owner meets a willing buyer with plenty of money in the bank. Each proposes a price for the transaction. After a little bit of negotiation, they meet in the middle, shake hands, sign the paperwork and the deal is done.
However, life is not always quite so simple. Buyers and sellers may not see eye-to-eye on price. A bank may not be willing to provide enough financing. In those cases, a deal becomes complicated quickly.
“In today’s market, certain deal structure – broadly defined as deferred or contingent payments – can be a valuable tool to bridge gaps in valuation, plug holes in the capital structure, and ultimately get the best deals to the finish line,” said Robert Jansen, managing director of Milwaukee-based Bridgewood Advisors.
For more than a decade, interest rates were incredibly low, making it relatively inexpensive for buyers to borrow money to finance a deal. That changed with the Federal Reserve hiking rates in 2022 and 2023 to combat inflation.
“As a result of the higher interest rates, the cost of money increases,” said Steve Boylan, a mergers and acquisitions advisor at Valens M&A. “This in turn can decrease the amount of money the bank is willing to loan and the buyer is willing to pay.”
Cheryl Aschenbrener, national leader and partner in transaction advisory services at Sikich LLP, said most private equity buyers add leverage or borrowing when making a deal to boost the return on investment. Higher rates and an uncertain environment dampened M&A market activity in 2023, she said.
“Most are predicting a return to higher activity as the Fed has signaled rates will be steady to lower,” Aschenbrener said.
Boylan noted that more business owners are beginning to accept that rates will not return to their recent low levels anytime soon.
“Once they accept the reality of the near future cost of money, the decision to bring the business to market is more likely,” he said.
In the event that a gap remains between what a buyer is bringing to the table through cash and financing and what the seller wants, there are a few available options.
For starters, the buyer could increase their upfront investment. Different types of buyers may be better positioned to bring more money to the table. A large strategic or corporate buyer is much more likely to be able to invest more than a group of employees looking to buy the company, for example.
Another option would be for the seller to provide financing to the deal. In that case, the buyer provides the seller with a note to repay debt over a set period of time with interest.
“That’s still pretty good because you have the rights of a creditor,” said John Emory Jr., president of Milwaukee-based investment banking firm Emory & Co. “A note is far better than an earnout. A lot of sellers in their mind tend to lump a seller note together with an earnout, but an earnout is typically far less valuable than a note. A note bears interest and you can enforce it.”
Aschenbrener said buyers opting to include seller financing in a deal is more common in cases challenged by low or inconsistent performance of the business.
Earnouts are arrangements in which the seller receives some portion of the value of the business based on whether the company is able to hit certain metrics over a set period of time. Emory said buyers will typically look to tie the metric to earnings while a seller might opt for revenue. Aschenbrener said earnouts are common with either inconsistent past performance or a future forecast that is high compared to the past.
“This protects the buyer from some risk, and also sometimes enables sellers to receive a higher overall multiple,” she said. “If earnings come in as expected, the buyer is essentially using those earnings in part to pay the seller.”
Aschenbrener noted that earnouts were especially more common in the first year or two after the pandemic as supply chain issues or demand changes injected anomalies into financial performance.
Another option for closing the gap in financing a deal is for the seller to roll over a portion of their equity in the business, maintaining a small ownership stake post-sale.
“Rollover equity is most common when selling to private equity,” Jansen said.
In many cases, private equity firms are looking to grow a business they acquire and then sell it after a handful of years. In the right circumstances, an owner could realize as much value in a subsequent sale from a 20% stake they held onto as they did from the 80% they initially sold.
Whether it’s seller financing, an earnout or rolling over equity, who the buyer is becomes more important as new elements are added to a deal.
“A seller’s confidence in the prospective buyer becomes exponentially important when deal structure is involved,” Jansen said. “Sellers should have high confidence in the buyer’s strategy, vision, ability to execute and ability to make future payments.”
In some cases, it may make sense for a seller to opt for a lower price if it means a simpler and more certain deal, Emory said.
