Earn-Out Workarounds? (Forgivable Note, Side Letter, Erosion Clause, Etc.?)

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12/01/2020 Redacted Redacted

searcher Harvard University - Harvard Business School United States Military Academy

EARN-OUT WORKAROUNDS? (FORGIVABLE NOTE, SIDE LETTER, EROSION CLAUSE, ETC.?)

I'm looking at a deal with significant volatility in[redacted]2x previous years), and unsurprisingly the owner claims the change the structural and wants to be paid for it. I'm looking for a way to de-risk the deal based on an "earn-out" while using an SBA loan. 

The easy answer here is that earn-outs are explicitly prohibited, but I keep hearing about potential work arounds where you can get the same function without it being considered as an earn-out by the lender. 

Thanks in advance for the help.

4 likes 175 views 11 comments

lender University of Missouri - Columbia - 12/01/2020

Hi Scott, contingent seller notes are a way to work on this. you can reach me at [redacted] and I can give you some examples.

like reply | 3 likes

searcher Harvard University - Harvard Business School United States Military Academy - 12/02/2020

Colin, I'll reach out shortly with a follow up. Thank you for the help!

like reply | 0 likes

admin Massachusetts Institute of Technology - MIT Sloan School of Management Taylor University Stanford University - Graduate School of Business - 12/01/2020

^[redacted]‌ - In addition to the comments you receive, you can find lenders under the Directory. Here is the direct link: www.searchfunder.com/user/list/lender

tagging a few lenders who can either answer your question directly or introduce you to someone who can. To my commenters, thank you in advance for making Searchfunder a helpful community. ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌

like reply | 0 likes

admin Massachusetts Institute of Technology - MIT Sloan School of Management Taylor University Stanford University - Graduate School of Business - 12/01/2020

Some of the lawyers on Searchfunder might also be in a position to help answer this question. Tagging a few of them to help get the ball rolling.

To my commenters, thank you in advance for making Searchfunder a helpful community. ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌, ^[redacted]‌

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lender - 12/01/2020

A forgivable seller note tied to existing 2020 performance is an SBA-eligible vehicle that you can use in this situation. This would only be considered an "earn out" if the metrics were based on growth rather than on existing performance being maintained. Please feel free to send me an e-mail if you'd like to discuss it further: [redacted]

like reply | 2 likes

searcher Harvard University - Harvard Business School United States Military Academy - 12/02/2020

Heather, great point. My mistake was scaling the target revenue by inflation, which in essence, makes the forgivable seller note into an earn-out. Thank you!

like reply | 0 likes

professional Northwestern University - Kellogg School of Management Northwestern University Washington University in St. Louis - 12/01/2020

I agree with Colin McNulty. I've used a 12 month post-closing purchase price adjustment in the purchase agreement and corresponding note reduction as a work-around and could share examples as well. A couple of other things to consider[redacted]I'd recommend using revenue as the metric rather than EBITDA or net income. Because there's less opportunity to manipulate revenue, it's much easier to negotiate in the definitive documents and avoids potential arguments, and 2) This structure may impact the fees the Seller may owe to his or her investment banker/business broker, so you want to make sure you both stay in front of that issue and you don't have a closing day blow-up. You can reach me at [redacted] if you want to discuss further.

like reply | 2 likes

searcher Harvard University - Harvard Business School United States Military Academy - 12/02/2020

Patrick, we've been going back and forth on this point. The seller obviously wants it based on revenue, whereas the bank wants it in terms of EBITDA. I agree with you that revenue is the cleanest way to approach the target and will hopefully result in fewer disputes down the road. Especially at this end of the market, an acrimonious dispute with the seller could materially impact business performance with his long-time customers.

On you point about additional feeds for the seller, how material of an increase are we talking? Should the additional expenses be baked into the price? Or is your point to just highlight the cost so there are no last minute surprises?

like reply | 0 likes

professional Northwestern University - Kellogg School of Management Northwestern University Washington University in St. Louis - 12/02/2020

I raised the point on broker fees really as a courtesy to the Seller. There may be an opportunity to negotiate the issue between Seller and broker if it's discussed well in advance of closing.

like reply | 0 likes

professional University of Minnesota - Twin Cities Campus - 12/07/2020

^[redacted]‌ and ^[redacted]‌ are making some great points. I would add that I think the first step should be to have a clear discussion with your lender about what they will allow. If they are going to be overly stringent with SBA requirements, consider finding another lender (there's a lot of tremendous options here on Searchfunder).

Once you know what your limitations are from the lender, I'd search out some high-level ideas (like what Patrick and Colin suggested, for example) and discuss this with Seller (if you are even remotely skeptical about Seller's broker/IB, if there is one, keep the broker out of this discussion because of the potential conflict of interest - make sure Seller knows you want to keep the broker out to potentially save SELLER money). If you and Seller can arrive at a plan that works between you (and the bank is good with it), you can each take that plan to your respective legal counsel and have them document it properly (and, as Patrick noted, make sure at some point you are clear with the broker on the issue of commissions based on the structure you have selected). If you get legal involved too early without a clear plan, having attorneys involved in the back-and-forth can get expensive quickly.

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searcher University of North Texas - 12/01/2020

In my VC days, using a variation of what ^[redacted]‌ did to make everybody happy. For me, this was in Canada so clearly different rules, no SBA loan (BDC in that case), etc. With respect to the the numbers, top line is the cleanest as you'll have the most control over variable. Top line (revenue) is straight up. The other observation is how much control do you have. By that I mean if the owner is an employee or still active after you close the deal, creating top line with crappy margins get him/her over that revenue number but is it 'good' revenue meaning good margins, contribution, etc. Good luck and happy to provide more perspective as you'd like. [redacted]

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