Earnout - Seller note - Equity proportion

December 20, 2022

by an investor from INSEAD in Budapest, Magyarország

Dear All,

Is there a general rule of thumb for buyout terms? What percentage is generally upfront? How much is the seller note? How much is earn out?

I understand one should max it out, but still curious what you can use as argument as general market practice?

Let's say 100 is the equity value,
50 is upfront
25 is seller note
25 is earnout?

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Reply by a searcher
from Carnegie Mellon University in Boulder, CO, USA

There isn't a one-size-fits-all rule for buyout terms, as they can vary significantly depending on numerous factors like the industry, the financial health and prospects of the business, the negotiation skills of the parties involved, and the specific circumstances of the deal. However, there are some general patterns that are often observed in buyouts. Upfront Payment: This is the cash paid at the time of the transaction. The percentage of the total deal value paid upfront can vary widely. In some cases, it could be as high as 70-80%, while in others, particularly where the buyer is cautious about the future prospects of the business, it might be lower. Your example of 50% is within a plausible range, but it's by no means a standard. Seller Note: This refers to a form of deferred payment where the seller finances part of the purchase price. It's essentially a loan from the seller to the buyer, paid back over time. The proportion of the deal structured as a seller note can vary, but it's commonly in the range of 10-30%. Again, this depends heavily on the specifics of the deal and the negotiating power of the parties. Earnout: An earnout is a contingent payment that depends on the future performance of the business. It's a way to bridge valuation gaps between buyer and seller, with the seller potentially receiving additional compensation if the business achieves certain milestones. The size of an earnout can vary greatly. It could be a small percentage of the deal or, in some cases, a significant portion if the future performance of the business is highly uncertain. In your example, dividing the equity value into 50% upfront, 25% seller note, and 25% earnout is a reasonable starting point for a discussion, but it's important to remember that these terms are highly negotiable and subject to change based on the specifics of the business and the negotiations between the buyer and seller. When negotiating a buyout, it's crucial to consider not just the percentages, but also the conditions attached to each component (e.g., the interest rate and term of the seller note, the performance metrics and timeline for the earnout) and the overall structure of the deal. Also, the risk tolerance, strategic goals, and financial health of both the buyer and seller play significant roles in shaping these terms.

Reply by an investor
from Columbia University in Dallas, TX, USA

Terms are highly variable. Seller Note are not always part, but, when there are Seller Notes, I most often see 10-30% range. Consider asking for an interest free period to give yourself a buffer. EO is also highly variable. I've seen much higher than 50%, but EO's are a hotbed of later disputes and finger-pointing. I think keeping EO modest -- say, in the 10-25% range is wise. But whether to have EO at all and how to structure will depend on who is staying on board, what the role is, and how align on their advertised expectations. You might also consider this: apart from EO, give them a less-strings-attached Holdback and/or "Deferred Consideration" -- paying out over the first 1-3 years. This is not something they have to hit a Rev/EBITDA benchmark for, but may be attractive to break up the price over a couple of periods (consider tax consequences), and a means to keep executives engaged and behaving well.

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