TRANSITION TALK

Shared Risk / Shared Reward - Financing Your Deal

Posted by David Grau Sr., JD on Mar 29, 2018 1:58:00 PM

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Setting up and agreeing to proper and reasonable payment terms is an essential part of the selling or acquisition process. The following questions are common for both buyer and seller when it comes to deal structuring, especially in regard to financing the transaction:

  • What types of financing are available?
  • What is seller financing?
  • How are payments structured to promote post-closing co-operation and motivation for both parties?
  • Are there contingencies to the payment of the full purchase price?
  • Does client attrition affect the final purchase price?

SELLER FINANCING

Underlying virtually every acquisition is the assumption that the seller will offer some kind of financing to support the transaction. There are four primary types of seller financing, the last three of which include contingencies that may alter the final purchase price.

  1. A basic promissory note
  2. An adjustable or performance-based promissory note
  3. An earn-out arrangement
  4. A revenue sharing or fee-splitting agreement

Seller financing is less a matter of the sufficiency of a buyer’s cash reserves and more the basic payment structure technique that recognizes the importance of keeping the seller motivated to help with post-closing client retention. Post-closing seller motivation and support is critical in a transaction that involves a relationship-based business.

Relatively few transactions of any size are struck with no cash down at closing. The most common structure for the sale or acquisition includes three distinct elements: 1) an asset-based transaction (as opposed to buying or selling stock); 2) a nonrefundable cash down payment; and 3) seller financing of the balance for two to five years. While seller financing is the most common payment structure for M&A deals in our industry, in recent years the availability of bank financing has become an increasingly prevalent acquisition tool. Sellers may prefer this route as well, as it increases the amount of the up-front payment and can reduce the seller’s risk in the transaction.

It is not unusual to employ both seller financing and bank financing in the same transaction. Bank financing can usually be amortized for up to 10 years, which makes it a powerful tool from the buyer’s perspective. Even so, bank financing is commonly used in conjunction with seller financing to ensure adequate post-closing motivation and to balance the risks. After all, if the clients don’t transfer and stay, the buyer has bought “a bag of air.” Smart payment structuring is intended to prevent this from occurring.

Seller financing usually contains some type of contingency to ensure that assets and cash flow transfers and can be retained for a specific period of time after the transaction has been closed. This type of financing for third-party transactions is often structured as a performance-based note, and, more rarely these days, as an earn-out arrangement.

Note: Contingent seller financing is appropriate for most third-party transactions. However, contingent seller financing is not used for internal sales or formal succession plans because transition risk is typically mitigated by client familiarity and a seller/business partner who continues to work alongside the advisor/investor.

THE "SHARED RISK / SHARED REWARD" CONCEPT

In a third-party transaction, the buyer is often a complete stranger to the client base before being introduced by the seller. A high post-closing client transition rate doesn’t happen automatically or by accident; everything from the initial valuation to the deal structure to the transition plan affects the final results.

By utilizing contingent seller financing for the majority of the purchase price and a significant, nonrefundable down payment for the buyer, most successful third-party transactions are created using this shared risk/shared reward format. Essentially, post-closing, buyer and seller need to work together to succeed.

For sellers, this isn’t a “hand over the keys” process where they wish the buyer “good luck” and say “good-bye”. Buyer and seller must work together after closing until the client base is informed and settled in. That’s more than just a contractual requirement. If post-closing transitions don’t go as smoothly as anticipated, the payment structuring contingencies will kick in and can significantly affect the final purchase price or value.

In order to balance the risks between a buyer and a seller, financing tools must be carefully considered and applied correctly. Many private attorneys who aren’t familiar with the industry often use terms like “earn-outs,” “revenue sharing” and “contingent seller financing” interchangeably. Even some of the practice management personnel at IBDs and custodians do the same, or even limit their solution set to the one primary financing method they understand and apply it to every transaction indiscriminately. The intricacies involved in the financing approach and the choice of contingencies affects every aspect of the sale or acquisition process. Avoidance of problems and mistakes is mostly a matter of knowledge, experience and application.

The shared risk/shared reward payment structure has had a positive effect on practice transitions in this industry–a consistent, post-closing, 98%+ client transition and retention rate on our watch–remarkable when you consider that most exit plans are external, not internal. Carefully consider the shared risk/shared reward concept when creating your own payment structure, especially if you elect to utilize some type of external or bank financing that substantially cashes out the seller at the time of closing.

The same is true in reverse, if you’re selling on a revenue-sharing basis with no down payment, then a buyer has no “skin in the game.” How hard are they going to work to keep the bottom half of the newly acquired client base? A buyer will usually work harder and be more motivated if they’ve paid a significant down payment and have to at least recapture that investment from a new group of clients.

Proven systems and processes derived from competitive open market transactions and payment structures, including contingent seller financing tools, are the keys to realizing and obtaining value in your transaction.

Topics: M&A, Financing, Buying & Selling

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