Selling your small business can easily be the largest transaction you’ll ever have, and the terms of the deal can greatly affect what you receive in the end when all is said and done.
Let’s take a look at a business owner who is contemplating two different offers. Offer A is from a strategic buyer who wants the owner to stay on for a few years with an earnout structure in place, which will get the owner to a final selling price around $6 million. Offer B is from an entrepreneur who is offering $4.5 million in cash for the whole kit and caboodle — business, client list, assets, etc. The owner could walk away next week with $4.5 million in the bank and never have to work in his business again.
So, which one is the better deal? Like so many things in finance, the answer is, “it depends.”
A business owner needs to consider what his own circumstances are. Does he need an immediate out because of health issues? Does he want the cash to invest in another business venture? Will this $4.5 million be enough for his retirement lifestyle once all other obligations are paid? If the answer is “yes” to any of these, a lower cash offer might be a good option.
A higher sale price with an earnout can also be structured to benefit both the seller and buyer. An earnout is where the business owner must earn a portion of the purchase price based on the performance of the business following the sale. Usually the business owner continues working under the new owner for a period of years. The earnout payments are often tied to how the business performs in the future. This can be good for the seller, as he can play a role in keeping the business going, keeping clients and vendor relationships intact, and making the transition smooth for all parties. The buyer gets the benefit of having an experienced executive to run daily operations. Furthermore, as the seller may be able to structure the earnout different ways, by participating in the upside growth, e.g., as the company grows and profits, earnout payments grow in step with the company. Or, the seller can set a floor, e.g., receiving no less than $200,000 per year, regardless of company performance.
Of course, earnouts come with risk. The buyer may run the business differently, which could affect the loyalty of customers or employees. There could also be factors that the new owner cannot control like a recession that affects profits across the entire industry.
Finally, the business owner should consider the time value of money. If his wealth is tied up in the business, he may carry the risk of lack of diversification. If an all-cash offer could be invested in a diversified portfolio of stocks over several years, the owner could be earning returns in the market that could equal what he receives in an earnout over the same time. If the threat of recession were to happen, a diversified portfolio may be better able to weather the storm than a single business could.
All business owners need to realize that all cash offers are rare. They assume the buyer has the cash or bank financing, which is often not the case for many small-business transactions. Sale offers come in many forms, and a Certified Exit Planning Adviser can help business owners look at the risks as well as the end results of the sale.