How to counter typical seller objections for earnout and seller note?

March 26, 2021

by a searcher in San Francisco, CA, USA

In almost every deal that I come across I encounter a typical seller objection for earnout or seller note along with lines of - "I will not be in control of the business post sale, so I do not want to have my sale proceeds over something that I'm not in control of in the form of an earnout or a seller note" - or a similar variant. Obviously as a buyer I do not want to give all of the amount as cash at closing and I do want to hold some back.

My question is - what is the most effective way for a buyer to counter this typical seller objection during initial negotiations?

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Reply by a searcher
from Ohio State University in Chicago, IL, USA

Thanks for the tag ^^redacted‌. I encountered this situation recently in a deal where there was approximately 30% of the purchase consideration tied up in an earn-out. The Seller was rightly concerned that we could make changes in the business post-close that could impact the level of sales or capacity, potentially impeding the earn-out. We ended up agreeing to include a post-closing covenant that delineated certain actions we would not take for a narrow period of time (for example, not reduce sales and marketing spend for a time). This is not ideal for a Buyer, obviously--we want to be able to make any decision we'd like since we own the business, but we were confident we didn't give up anything that really mattered, the term was short, and the Seller was happy. You might ask the Seller what specific actions he/she is worried about, and consider agreeing to avoid those for a narrow time if you have no other options. I would first try to explain that you won't do anything to impede the earn-out (which is perhaps illegal according to a few lawyers I work with), that you will do what is best for the business in the long term which will protect the earn-out and the value of the Company, or blame the lenders. If none of these appeals to logic works, you might as a last resort consider the above option. If the gap is very small, maybe try to pay the money through a royalty, a paid board seat, a consulting agreement, a license of some sort, anything that could be more flexible than introducing structure into your agreement, which is not ideal. I am not an attorney so this is not legal advice, just my practical experience. Consult your attorney!

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

1) A typical SF buyer does not have the experience of running a business. Education, nor industry experience, is not a substitute for experience of running a business, managing people, maintaining customer/supplier relationships, servicing debt, etc. Hence, seller is concerned about seller notes and earn-outs.
2) On the other hand no seller has a "perfect" business. Even audited financials can be managed. Seller Note is for risk mitigation. 100% DD is impossible. A seller note is a means to get some assurance that the seller is not passing a lemon###-###-#### % is common for risk mitigation. Seller note can also be justified for price preservation when financing get tight.
3) Earn-out is warranted if there is a business risk that is beyond the control of the owner (the seller or the buyer). Seller will not accept earn-out for a stable business. Contrary to common thinking, earn-out is not a means of bridging a value gap unless the the business is expected to have a high growth, in which case, earn-out can bridge the value gap driven by difference in expected growth. So, for a stable business seller would resist earn-out.
4) Alternatives to Seller Note are larger escrow, tighter R&W, etc.
5) Post-transaction covenants (there are many) can also be used to calm Seller fear on Seller Note. That usually does not work with earn-outs.

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