M&A Valuation Gaps or Seller “Skin in the Game”: Notes, Earnouts and Equity Rollovers

Private company sellers and buyers usually have different ideas about a company’s valuation or the purchase price for a merger or acquisition deal. And after the price is agreed, buyers often seek to minimize the cash they have to pay at closing, and to ensure that the sellers continue to have some “skin in the game.” They may do this with by paying a portion of the deal price with (i) a promissory note from the buyer, (ii) one or more post-closing “earnout” payments, (iii) some equity retention or “rollover” (i.e., exchange of target equity for newco equity) by the owners or management, or (iv) some combination of all of these. Each of these deal tools carries more seller risk than closing cash and, if they are used, they should be carefully structured by the sellers and their legal and tax advisers.

Seller Note

In some deals, the buyer will pay some of the purchase price in cash at closing and issue a promissory note to the sellers providing for monthly, quarterly or annual payments of principal and interest for some period of time following the closing. The sellers’ risks in accepting a seller note include (i) the risk that the buyer will not be able to make all payments under the note, (ii) the risk that the note will be subordinated to the debt of the buyer used to make the acquisition, and (iii) the risk that the note may be subject to “offset” or reduction for indemnification claims by the buyer following the closing (e.g., for seller breaches of representations and warranties). Sellers and their advisers should seek to reduce these risks by (a) securing the note with some form of collateral (such as a stock pledge) or a guaranty by a creditworthy affiliate entity of the buyer, (b) negotiating fair subordination terms with the buyer’s “leveraged buyout” lenders, and (c) objecting to any buyer offset rights (or at least structuring the sellers’ representations, warranties and indemnification obligations in a way that minimizes the chance that the buyer will elect not to repay the note due to alleged seller breaches). Sellers should check with their tax advisers to ensure that they will not have to pay tax on the note amount unless and until payments are received.

Earnout

An earnout is more risky than a seller note because it is only payable in the event the acquired business achieves specified revenue, EBITDA or agreed targets, financial metrics or other “milestones”. Earnout payments typically are paid in cash (although occasionally they are paid in equity) and run from 1 to 3 years following the closing. They are sometimes tied to an obligation of management to remain with the company for some period, but not always. Revenue, customer or other earnout milestones are safer than EBITDA milestones given a buyer’s ability to manipulate EBITDA results with overhead and expenses. In any case, earnouts should be carefully drafted to ensure that they are clear, that the buyer’s running of the business will be reasonably managed to protect the earnout (e.g., by excluding certain unusual expenses from EBITDA and requiring certain good faith buyer support of the business), and that the sellers have the right to review and dispute (and, if necessary, to arbitrate or litigate) the buyer’s determination of milestone achievement or failure and the amount of the earnout payments.

The earnout terms should address what happens if the company is resold prior to full payment of the earnout installments. If the earnout includes multiple payments over multiple periods, its terms should specify whether any prior period poor performance can be made up by subsequent period over performance (i.e., a “catchup” or “make whole” provision). The earnout terms should specify any minimum payment amount or any cap (or maximum payment), and whether the earnout is “all or nothing” or payable in part based on graduated milestone achievement. If the buyer is a newly-formed entity, the earnout should be guaranteed by a creditworthy parent or affiliate of the buyer.

Most important, the sellers should be comfortable that the earnout milestones are achievable, that the buyer will operate the business in a way that reasonably ensures such achievement, that the buyer has no or limited offset rights, and that the future relationship of the sellers and buyer is important enough (e.g., continued seller or management employment) that the buyer will have the incentive to make good on its earnout promise. Proper planning is required to ensure that earnout payments will be taxable as capital gain from sale (preferably under the “installment sale method”) as opposed to compensation. As with a seller note or equity rollover, the ultimate terms of any earnout will depend upon the seller’s negotiating leverage.

Equity Rollovers

Especially in private company sales to private equity buyers, it is quite common for the sellers or management to retain some equity stake in the go-forward buyer or “newco” entity (often from 10% to 20%) that will own the business. While this also carries more seller risk than receiving all cash, it also presents sellers with the potential to share in the upside (i.e., the future appreciation in the company’s value). At the outset, sellers will want to ensure that their retained or exchanged equity will not be subject to immediate tax in addition to any tax payable on the cash portion of the deal. This creates some tension in structuring an M&A transaction, as buyers typically want the benefits of a “stepped-up basis” in the target company’s assets, which reduces the after-tax cost of the deal to the buyer. Sellers should therefore consult with good tax advisers as to the best way to structure any equity rollover.

In most cases, a private equity buyout will be structured as an equity (stock or LLC shares) purchase rather than an asset purchase, but be tailored to give the buyer its anticipated tax benefits while, at the same time, permitting a tax-deferred rollover of equity by the founders or management. An asset purchase or even the purchase of stock in an S corporation with a so-called “Section 338(h)(10)” tax election will usually not permit a tax-deferred equity rollover. But, whether the target company is a C or S corporation or an LLC, there are several well-accepted ways to achieve both the buyer’s tax objectives and the owners’ tax-deferred equity rollover. Again, competent tax advice is imperative to achieve the right result.

Aside from getting the valuation and tax aspects of an equity rollover right, sellers will want to negotiate agreements with the buyer that protect the value and future liquidity of their minority equity ownership in the go-forward business. Sellers’ legal counsel should negotiate for terms that minimize the risk that their equity can be forfeited or repurchased at some bargain price, and to ensure that they will participate with the new controlling owners in all future dividends and sale transactions.

Take Aways

Seller notes, earnouts and founder or management equity rollovers make M&A deals more complicated and require more work than all cash deals. But, when they are necessary to get a deal done, sellers should be prepared to negotiate their terms to minimize risk and maximize their future value. While seller notes and earnouts are geared more toward bridging the seller-buyer price gap, equity rollovers can provide founders and management with a significant “second bite at the apple” when a private equity buyer resells the business in 3 to 7 years. The sellers’ willingness to accept any of these non-cash forms of deal consideration will depend not only on their negotiating leverage and the current market, but on their own assessment of the overall deal and the amount of cash they will receive at the closing of a transaction.