Terms When Selling a Business: Seller Carry Back and Earn-Outs
Updated: Jun 9
This is part 1 of an Exit Story interview with Lamar Rutherford.
Learn from a business broker about the importance of Seller Carry Back and Earn-Outs in successful business transitions.
I’ve personally owned three businesses that I've sold. And as a consultative business broker, I've sold many businesses in many industries.
I was a CPA at Arthur Anderson in Boston. I decided to open a bagel shop, because I thought it would help me learn about business which would help me in grad school. And I wanted to get my MBA. So, I left Arthur Anderson and learned to make bagels at a local shop where I used to eat lunch. It was a growing industry at the time, only 20% of the U.S. population had ever tried a bagel.
I moved back to Seattle where I grew up. There were fewer bagel shops there, so I thought it was an opportunity. (And although I'm not Jewish. I did get recruited by the Jewish softball team!) I ran the bagel shop for two years, and then went and got my MBA at Dartmouth. (While I was gone, I coached my mom through running the shop for a few years, and then my sister-in-law ran it for a couple of years.)
The Sale of My First Business, Lesson #1 – If You’re Going to Carry Back a Note, Be Sure the Buyer Has the Expertise to Run the Business My sister-in-law was pregnant with her second child, and my mom didn’t really want to go back to running the shop. I was working for Nestle in Los Angeles doing consumer marketing in their candy division. I decided that we should sell the bagel shop, because I had no plans to go back to Seattle and open more bagel shops.
A woman that worked for us was interested in buying the shop. She'd always wanted to work as a baker, so I thought the sale to her made sense. But, unfortunately, it turned out to be one of those valuable lessons. I learned about the risks of a seller carry note. You can’t always count on the money.
We got a good portion of the price at close, but part of the purchase price was to be paid over time as a seller carry note. Unfortunately, the new owner did not manage well and ended up running the business into the ground in the first year. We tried to help, but she had an ex-boyfriend that had been in the food business. I think every time something went wrong, she had an excuse to call him. Sadly, his counsel didn’t save the business.
So, we didn't get the full payment on that business. That’s one thing I try and advise sellers about -- you really have to know the risk of payments over time. There are some benefits. If you get paid over time, you can stretch out the tax payments, usually to years when you’re likely to be in a lower tax bracket. But you have to assess the risks carefully
It's always ultimately the seller that has control over deciding if the buyers are a good fit culturally and have the experience. Because even if there isn't a seller carry note or an earn out to be paid over time, it's still better to have the business continue after the sale.
Ultimately, I believe, it's one reason for selling a business versus simply closing it -- to keep the jobs that fuel our economy and give people their livelihood.
As the business owner, you don't want to sell and then have the business fail. Sometimes, the buyer with the best qualifications doesn't always pay the most, but it might be better in the long run.
Types of Buyers and the Art of the Seller Carry Back in a Sale There are different types of buyers:
1. Individuals: In most deals with a sales price under $5 million, the seller will usually sell to individuals.
2. Private equity or “financial” buyers. They're really looking for the investment and the return.
3. Industry or “strategic” buyer.
Each of these three types of buyers are often looking for different things in a business purchase. Individuals typically don't have the funds to do a large purchase. They're usually looking for smaller businesses under $5 million (the SBA will lend up to $5 million).
Some individual buyers are very sophisticated, have bought multiple businesses, and will buy more. But a lot of individual buyers don’t have the financial resources, so a seller carry note is basically where you are loaning the funds to the buyer for them to pay you out of the proceeds earned by the business over time.
For example, for a $1 million sale, the buyer might put down $800,000 and you might carry $200,000 that the buyer will pay you over time.
One of the calculations you always want to do: they generally pay you out of the profits of the business. So, it's helpful to do that calculation of what's the monthly nut they have to cover. If it's way out of range, like if they have to pay the $200,000 in 12 months and the business is only making $200,000 per year, then unless they have other resources, you're setting them up to fail.
Understanding Earn-Outs An earn-out is based on performance results, where the seller receives future payments if the business achieves certain goals. So, in the same scenario as above, the $200,000 could be an earn-out instead of a seller carry note.
With an earn-out, you wouldn’t get your money unless the company performed to a certain measure. Sellers are always bullish on how their business is going to perform down the road – and buyers are always nervous that they’re going to miss something, and the performance won’t be as strong as expected. So, an earn-out can bridge that gap.
if you can avoid seller carry back notes or earn-outs on a smaller business, I would. And I never advise more than 20% for a seller carry note. We try to avoid earn-outs at all costs, but sometimes that's the only way to get the deal done. Earn-outs often come into play for fast growing businesses where your numbers don't justify a high price, but you know you're going to get that value down the road.
Earn-outs are really an area where there's a lot of miscommunications about how the financial goals will be calculated. Even revenues, the simplest measure, leave some room for monkeying with the numbers. The buyer might “adjust” revenues by pushing sales forward, or postpone a big customer order right after the deadline for the earn-out calculation
So, basing an earn-out on revenue can be a challenge. If it's based on gross margin, which is fairer for the buyer, there’s more risk to the seller because that measure can be monkeyed with more than revenues.
It’s even worse if the measure of the earn-out is based on net profits. Then, the buyer can push through all kinds of expenses, like marketing expenses that might be valid expenses, but might lower the profit.
All of these different financial goals can create problems down the road. But the best deals are where you don't get into litigation. Becoming an educated seller about deal terms can help avoid problems.