Cash at Closing, Earnouts and Seller Notes: How to Read the Terms of an Offer

When an owner gets a first offer on a company, the eye goes straight to one number. That is natural. It is also the fastest way to misread the offer.

The price on the first page is what a buyer is willing to pay. I explained how a buyer gets to that number in How a Buyer Values a Small Business. The terms underneath tell you when you get paid, how much of it is certain, and what you are agreeing to after you sign. Two offers with the same headline number can be very different deals.

Here is how I would read one, part by part.

Cash at closing

This is the money that arrives when the deal closes. It is the most certain part of any offer, and for most owners it is the part that matters most.

Ask for the number in writing, and ask what comes out of it. Debt the company owes is usually paid off at closing. Fees for lawyers and advisers come out. Part of the price may be held back for a period, which I cover below. The figure you take home on closing day can be well below the headline, and you should know it before you compare offers.

Seller notes

A seller note means you lend part of the price back to the buyer, and they pay you over time with interest. It is common in small company sales, and it is not a bad sign on its own. It often lets a buyer pay a fair price without borrowing more than the company can carry.

The questions are practical. How long is the note? What is the interest rate? Is it paid monthly, or all at the end? What happens if the company has a bad year? And who else gets paid first if something goes wrong? If a bank is lending to the buyer too, the bank is usually paid ahead of you.

Earnouts

An earnout ties part of the price to how the company performs after the sale. If revenue or earnings hit a target, you receive more.

Earnouts can bridge a real gap. If you believe next year will be strong and the buyer is not sure, an earnout lets both of you be right. But they are also where many disputes start, because after closing you no longer control the decisions that drive the numbers.

If an offer includes one, read the definition of the target closely. Is it revenue, which is simple to measure, or earnings, which depend on what costs the new owner puts on the books? How long does it run? What happens if the buyer merges your company into another one? An earnout you cannot measure clearly is worth less than it looks.

Rollover equity

Some buyers ask the owner to keep a share of the company, or to take part of the price as ownership in the buyer's business. That is called rolling over equity.

It can be a good deal if you believe in where the business is going and trust the people running it. It also means part of your payment depends on a future sale or a future dividend that you do not control. Ask when and how that stake could ever turn into cash.

Holdbacks and adjustments

Most purchase agreements hold back part of the price for a period after closing in case problems surface that were not disclosed. Ask how much, for how long, and what has to happen for it to be released.

There is also usually an adjustment for working capital, the cash, receivables and inventory the business needs to run day to day. The buyer expects a normal level to be left in the company. If there is less at closing, the price goes down. I wrote about this in What a Buyer Actually Looks At in Your Financials. It surprises more owners than any other term.

The terms that are not about money

Some of the most important lines in an offer have nothing to do with dollars.

• Your employees. Will the buyer keep them? Will pay and benefits stay the same? I wrote more on this in What Happens to Your Employees When You Sell Your Company.
• Your name. Will the company keep it?
• Your role. How long are you expected to stay, in what job, and at what pay? Are you agreeing not to compete, and for how long?
• Exclusivity. Most letters of intent ask you to stop talking to other buyers for a set period. Know how long that is before you sign.

Putting two offers side by side

A simple example, with made-up numbers. Offer A is $5 million, with $3 million at closing, a $1 million seller note over five years, and a $1 million earnout based on earnings. Offer B is $4.6 million, with $4.2 million at closing and $400,000 held back for 18 months.

Offer A has the bigger headline. Offer B puts more cash in your hands on day one, and almost all of it is certain. Which is better depends on how much you trust the buyer, how confident you are in the next few years, and what you need the money for. The point is that you cannot tell from the headline.

When I compare offers, I write each one out the same way: cash at closing, what is deferred and on what terms, what depends on performance, and the terms for people, name and role. The better deal is usually obvious once it is all on one page.

How we approach it at Creek Equity

At Creek Equity we invest our own capital, not a fund's, so we have no deadline to sell what we buy. When we make an offer, we walk the owner through it line by line: the earnings figure, the adjustments, the multiple and the terms. An owner who understands the offer can compare it fairly with others, and we are comfortable with that.

If you have an offer in hand, or expect one, and want a second set of eyes on how it is structured, write to me at scott@creekequity.com. The first conversation is with me directly.