Each week clients ask me how to construct an offer for a business target that has (a) inconsistent EBITDA/Revenue; (b) an outlier prior year; (c) high pro forma revenue (usually with some assertion of certainty, i.e., based on new a customer secured).

Naturally, sellers want to sell their business valued upon the peak of the trailing 12 months’ revenue.

However, buyers (and lenders) do not feel comfortable underwriting numbers that seem uncertain or unlikely to represent the future performance of the business.

How should a buyer structure an offer for a business like this?

Option #1, of course, is to offer a number based on the trailing 2 or 3-year average. But, since the seller is certain the business should be valued on the high number from the past year (or even the pro forma numbers), the seller will likely not entertain an offer that does not account for the higher numbers and the bidder will not win the deal.
Enter: The Contingent Purchase Price.

Let’s say you believe the seller that the higher valuation is correct. Even if you wanted to make a non-contingent offer, your lender and financial partners will be hesitant.

You must break out the purchase price into two components: (1) Base Purchase Price; and (2) Contingent Purchase Price. Adding a contingent component shifts the risk to the Seller that their financial assertions are correct.

The Base Purchase Price should peg the more consistent financials and be paid at closing. The Contingent Purchase Price should peg the higher financials and be paid after closing, contingent on proving the efficacy of the higher numbers.

In our (dramatic) example, EBITDA is $1M, $1.2M and $3.8M. We can verify the $3.8M is a result of new customers or market trends and this number will be the new normal.

The multiple is 4.5x EBITDA. Seller would love an offer on trailing 12, at $17.1M.

Buyer would prefer to take the most conservative view and calculate the purchase price based on the 3-year average = $9M (there may be a good argument for using trailing 2 years here = $11.25M) (See Twitter post for the graphics: https://x.com/Eli_Albrecht/status/1744360762972237909?s=20).

However, there is no chance seller sells at $9M when last year was $3.8m in EBITDA and Buyer cannot offer $17.1M when trailing 12 was a breakout year.

Thus, we want to take a Base PP of $9M and add a Contingent PP of $8.1M to get to an all-in potential PP of $17.1.
If the seller is right about the financials, Seller will get the full purchase price, but buyer and its financial partners will be much happier knowing that the risk of a lower EBITDA is on the seller and if it turns out seller is wrong, the purchase price is retroactively adjusted down.

The following are the mechanisms for the Contingent portion:

1. Forgivable Promissory Note. In our example, Seller lends $8.1M to buyer contingent on attaining certain post-closing metrics. If not attained, part or all of the promissory note is forgiven.

2. Earn-Out. For an earn-out, the $8.1M will only be paid by buyer if metrics are achieved. This would be dependent on proving out Seller’s assertions on the EBITDA/Revenue/Profit in future years. Earn-outs are flexible; they can be on a sliding scale, a portion of profit/revenue, etc. Note: SBA 7(a) lenders do not allow earn-outs; only forgivable notes. Here is a simple buyer-favorable Earn-Out example assuming no sliding scale; paid over 5 years; based on TT12 revenue targets; 5% increases each year:
3. Consulting or Sales-Bonus Agreement. I have constructed deals where the Buyer pays out the additional $8.1M as consulting or sales bonus to Seller contingent on maintaining certain customers or bringing in new relationships.

4. Rollover Equity. This is equity that can vest in Buyer’s business post-closing. This can be structured creatively to look like an earnout. SBA 7a Note: Partial change in ownership is allowed, but vesting rollover equity is not.

Challenges. Sellers hate contingent purchase prices. They often feel they cannot count on ever seeing that money. Furthermore, every single seller believes the new buyer will tank the business. I often hear, I know the business can sustain this EBITDA if I am in charge, but not if you, the buyer mismanage the business.

Finally, a good Sellers’ lawyer will ask for operating covenants. This means that Buyer will agree to run the business in the ordinary course prior to closing, and often includes restrictions on running the business post-closing until Seller has been paid. Operating covenants can include: (a) a level of work hours consistent with pre-closing; (b) marketing budgets; (c) employee levels; and (d) limits on expenses (if using EBITDA or profit). The Seller will also ask for information rights.

If an operating covenant is breached by buyer after closing, often the seller will demand phantom consideration, which is difficult to calculate. For example, if after closing, Buyer decreases the marketing budget resulting in a lower contingent payment to seller, seller will want to add back the value such seller would have had, had the budget remained the same.

This can get very complicated and often results in disputes during the negotiation and post-closing.

While contingent purchase price can be a powerful tool, I’ll leave you with a word of caution from my mentor, “An Earn Out is a lawyer’s best friend because it always results in litigation.”