When a company is taken over, a price is paid for the shares and risks are shared between buyer and seller. These matters are given a place in the purchase agreement.
An important part of the purchase agreement is the purchase price, which is often based on the (future) earning capacity of the company. If the earning capacity changes in terms of size and certainty in the future compared to the past, then this will have consequences for the purchase price and the method of payment. There are various possibilities to make agreements about this, each with its own advantages and disadvantages. It is important to record these agreements properly to avoid discussions afterwards.
Suppose that you as an entrepreneur are negotiating to sell your company to an interested party. It may happen that revenue or result development to be achieved in the coming years is seen as achievable by the seller but challenging or insufficiently predictable by a buyer. Obviously, achieving a higher result is also to the advantage of the buyer but the buyer will not always want to pay (in full) for this in advance. In this case, a buyer can propose to pay part of the purchase price at a later date by means of a vendor loan, earn-out or a ratchet arrangement if the forecast has (partially) become reality. These different methods are briefly explained below.
Vendor loan
A vendor loan is a loan made by seller to buyer and in this way the amount a buyer has to pay on closing is reduced. The loan is repaid over a number of years and is often subordinated to the bank. Repayment is made after bank approval and after any bank acquisition financing has been repaid. The loan has a higher interest rate than bank financing because of its higher risk profile. Basically, a vendor loan is not linked to performance or is linked to a limited extent.
This mechanism therefore works well at a time when the difference of opinion regarding performance is limited and a commitment by the seller through a financial interest is desired. Incidentally, an advantage for the seller is that part of the purchase price can immediately pay off at an attractive interest rate with a party he logically knows well.
Incidentally, we also regularly see a performance-based vendor loan, which is a vendor loan linked to the future performance of the company. If certain results are not achieved, the loan is (partially) written off and thus not repaid. With this, a performance-based vendor loan has a similar effect as an earn-out, but it sounds safer and more attractive to a seller without actually being so. Unlike an earn-out, the vendor does receive interest on the outstanding portion of the vendor loan.
Earn-out
An earn-out is a mechanism to bridge (larger) differences of opinion regarding the expected future performance of the company. With an earn-out, part of the purchase price is linked to the performance of the company. The purchase contract then stipulates that a seller is entitled to a certain subsequent payment if the company has achieved a certain financial target at a predetermined time. Here the earn-out is often linked to revenue, gross margin or profitability(EBITDA) in the coming years.
However, situations may arise where the interests of buyer and seller differ. Indeed, sellers may have no or limited influence on the results, while the earn-out payment is based on this. It is important to make clear agreements in the purchase agreement to protect the seller's interests (earn-out protection). This includes, for example, that a buyer cannot charge extra costs, that costs and revenue are accounted for in the same way (no relocation) or that the company is continued in the same way. In a general sense, the higher the reference of the earn-out is put in the income statement (revenue or gross margin), the less the outcomes can be affected.
Realize as a seller, that in a situation where the earn-out has been agreed upon and the company has been sold, that externa factors (such as a war, a pandemic or high inflation) can have a major impact on the company's financial performance and therefore on the feasibility of the financial objectives.
Ratchet
In a sale to private equity, a seller usually remains an (indirect) shareholder in the company. This allows the entrepreneur to cash in on some of his accumulated value and then continue to grow with private equity and profit from it. At the time of an exit, then both the investor and the entrepreneur have made an attractive return.
However, even in a sale to private equity, a difference of opinion may be present regarding the structural profitability that will be settled on. In that case, parties can also opt for a ratchet mechanism. An additional payment is made to sellers at the moment a certain pre-agreed success or return is achieved with a sale. This additional payment takes precedence over the shareholders' sale proceeds. A ratchet usually has a longer term than an earn-out because the mechanism runs until the time of exit.
An important advantage of this is that temporarily lesser results can be better absorbed because of the longer term and the investor can assume that the ratchet will only be paid at the time of success on the investment.
Advice
In many cases there are differences of opinion regarding the amount of the purchase price and/or structural profitability. There are plenty of ways to overcome these differences but each has its own advantages and disadvantages. It is therefore advisable to consult with an adviser to discuss which options are a good fit for your case and what this could mean for you.
