100% earnout for distressed business?

June 04, 2024

by a searcher from The University of Michigan - Stephen M. Ross School of Business in Boston, MA, USA

Hi
Has anyone if the SF community seen a deal for a distressed business where the price/consideration there is a 100% earnout. Basically if turnaround succeeds they get something but if it doesn't they get nothing. I saw a CIM for a distressed business where the owner is willing to leave working capital in the business, but it is unclear if the business has been irreparably damaged. I have related industry experience so it is of some interest to me.

Jeff

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Reply by a professional
from University of Virginia in Holmes, NY 12531, USA

^Luke Tatone‌ - thanks for the tag. My background is in distressed, I'm not certain I've seen an acquisition structure that is 100% earnout contingent - but, in the abstract at least, it is often useful to model these opportunities as deeply out-of-the-money real options (simplifying, probabilistically, your return is nothing, but with a small possibility of upside). As others have rightly noted, this is going to be exceptionally fact-dependent. Is the nature of the distress operational, financial, or both? Can the biz pay its ordinary course bills now? Is it solvent (from both an income statement and balance sheet perspective). The existing capital structure is crucial. If there's debt, it's of course going to have priority over the equity in a bankruptcy. If there's no debt, you may actually want to consider structuring the investment as first-lien senior secured loan with provisions for equity conversion (plus, you'll be able to credit bid in a chapter 11 proceeding). If the company is getting into that zone where a chapter 11 filing seems likely, you may well be able to extend a superpriority DIP Loan and/or get the assets at fire sale prices in 363(a) sale. Your note that existing ownership is willing to leave some working capital does suggest that perhaps the biz isn't cash flow insolvent, at least not yet. No matter the approach, you want this to be an asset acquisition, without successor liability. And if there are current creditors, you may also want to reach out with them and take their temp on possible collaboration. These thoughts are just top of the head and only scratch the service, neither legal nor financial counsel. But I'd be happy to have a look at details. Please feel to DM anytime and all the best, MB

Reply by a searcher
from University of California, Berkeley in Seattle Metropolitan Area, WA, USA

Thank you for the tag ^redacted‌ - have seen a handful of these. Really depends on what you mean by distressed and how far it's gotten. Liquidity/cash crunch? Debt that has bogged them down? I think these deals can work out if there's an honest/open discussion between buyer/seller. I've seen some deals drag on (up to 2+ years) and others that have gotten done and closed in < 30 days.
With working capital remaining, what form does that come in? Will buyer need to inject some additional equity to get turned around (often)? A timeline that incentivizes each side to work together in the near term to facilitate a smooth transition, help maintain the necessary relationships (vendors/suppliers/customers/employees) for the continuation, particularly if everyone is hoping for a successful outcome.
Lots of things can occur to put a business into that position, so it really depends on the nature/timeline. Creative structures around a seller note / earnout and titling of some of the inventory/assets can be a workaround to ensure there's a vested interest and that the buyer is working to make payments for full ownership of useful assets. I say this because TIME may be the most important factor here in ensuring it doesn't fail and slow/deliberate diligence by those providers who don't have horses in the race could be killer.

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