Most sellers expect – and hope – that the deal is done when the money hits their bank account. And that is a milestone – cause to celebrate your accomplishment.
But there may be clauses in sales contracts that prolong or delay the full buyout, and it’s important for a seller to understand how terms in the agreement might affect their ability to walk away with all the money the seller agreed to. Here are some of them.
The owner agrees to work in the company for a period of time. Generally, when owners agree to a transitional period, they’re not drawing a salary. It’s one reason to think long and hard about agreeing to this; you’ll be doing the same job you’ve been doing for years – without full authority over decisions. You’ll be an unpaid employee in the business you were ready to leave, instead of playing golf daily.
The seller agrees to earn outs or rolling equity into the deal. I’ve written about this before. Owners who sell to professional buyers (Private Equity firms) are often offered different deal structures than sellers with a cash buyer. The terms “rolling equity” and “second bite of the apple” may arise.
PE firms buy companies intending to sell them in 3-5 years. These buyers have capital to invest, but may not have expertise in running the company they’re acquiring. For this reason, they’d prefer to keep the owner involved in the business while they work to grow it.
The best way to do that is to ask the seller to roll some of their equity – profits from the sale – back into the business. The seller takes their share of the profits in cash, usually rolling around 25% of the equity into the new company. They are often retained as a minority owner and as a general manager to keep the company running smoothly and profitably for the next few years.
But this involves risk. You’re risking your profit from the sale if the market changes or the new owners don’t make good business decisions. I’ve seen sellers lose everything they rolled into the new business.
Earn-outs are deferred earnings from the sale based on the company’s future performance. I don’t work on many of these deals because I believe the seller should get full payment for the company they’ve built up to the time of the sale. What happens in the future is out of their control, and I believe that no owner should bet his retirement on someone else’s business sense.
The contract includes representations and warranties. This is the only real protection a buyer has against a seller who might have misrepresented or been untruthful about his debts at the time of the sale. Owners’ warranty, for example, that they’ve paid out all the vacation time owed to employees. They warranty that they’ve filed all their tax forms correctly, paid all sales tax and payroll taxes, and don’t owe any vendors significant amounts of money.
They may also warranty that they’ve maintained all their vehicles and equipment properly, and that there are no pending lawsuits or other legal issues that will come up. If the buyer requests a holdback (commonly, about 10% of the sale price for about 12 months), that money will be held in escrow until the buyer is assured that there are no material reasons to hold back money. The funds involved have to be significant (no buyer can claw back money based on a $50 error in sales tax) and must prove that the seller misrepresented what was warrantied. Claw backs are rare, thank goodness, because most sellers are honest and want a clean close to the deal.
But all this complexity means that the seller could easily agree to something that’s not in their best interest down the road. That’s why I always recommend that sellers choose a broker with industry experience and legal representation from someone with experience in selling HVAC and plumbing companies.
Want to find out what your company is worth? Click here.
