Types of Upside: More than the sales price

In this episode, we dive into the different types of upside in business transactions beyond just the sales price. We discuss seller financing, rolled equity, and how these structures can create value for both buyers and sellers. The episode includes real-life examples of deals that have gone well and some that haven’t, offering insights into how to navigate these financial strategies effectively. Tune in to learn how to use these tools to your advantage when selling your business.

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TRANSCRIPT:

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has

partnered with small business owners to prepare for and navigate the business

transaction process. Pull up a chair as we share stories and insights from our

experience on all sides of the M &A table. - All right, hey, welcome today's podcast.

Um, before we get going, I just want to, we just came off of the solar eclipse or

a day, we're a day after the solar eclipse. So what were y 'all's thoughts? Where

were you? What'd you do to reign in the day? Oh, that's good. Well,

um, Andrew, you want to go first because yours is pretty exciting. You're kind of

having your own color eclipse, weren't

(laughing) - Yeah, yeah, I guess you could say that. - You're kind of seeing some of

your own shadows or kind of like that? (laughing) - I was being mooned, yeah.

I was in the middle of a, in a dark room, looking at a sonogram of,

'cause we're expecting and so we went to see our 20 week appointment or whatever it

is and

got to experiencing my, um, unborn baby and see the little alien as,

uh, as, as the moon went across the sun. So I missed that, but I,

I, I, uh, I got to see what actually counts. So you should have run out in the

middle of it. She just ran out in the middle. I'll be right back. I mean, gone

out and taken a peek. You know, it's funny. My, my, my wife, my wife actually

said, uh, to the, said to the tech, she said, you know, you could hurry up a

little bit. Maybe we can catch the end of it, didn't you? And I looked at it and

I said, I don't think this is something that we want to hurry up.

Well, I'll ask you later if there's been a big gender reveal out of this, out of

this diagram. So, so as Mason, as you know, I live up in the Seattle area.

And so I was Watching it on the news and watching, you know, like in Mexico and

then I would curvil Texas and I was like, Oh, this is really great. And I'm like,

I kept looking outside going at the peak of it, at the peak of it.

That's me in Seattle. We got nothing. We got clouds and maybe,

maybe I think we only got like 22 % coverage, but we never even saw of it covered

or not because it's always kind and dark and cloudy so my favorite thing in this

quarter eclipse. Yeah, my favorite thing about it, my favorite thing about it was

when it was about five minutes after it was I mean you could still we went outside

to see it we kind of saw the little sliver which is really cool but my favorite

thing was when we were driving after the appointment you could see everybody went

outside, right? Everybody went outside. But no one's looking. No one is.

I mean, there were maybe a handful, but everybody's looking at their phone. It was

like, you came outside and you're looking at your phone. Mason, where were you?

I was at home, worked from home, and stood out in the street and watched it. And

I, you know, It was a great experience, really cool. Thought it was a little

anticlimactic though. They overhyped it. I think they said,

yeah, it's gonna be completely dark. Be safe driving, you know, all this kind of

stuff. It was never completely dark. I mean, it got dark, but I think they set the

bar too on it. - I was told, but I was told that Uber driver, a friend of mine,

he had to turn on his headlights during it. - That's fake. So yeah, yeah.

Well, yeah Well, that's well, we probably ought to get into the podcast with us.

Yeah, let's get on in the podcast Let's get started. This is gonna air a few weeks

after the

People listen this thing you go, what eclipse were you talking about? Oh, yeah They

can they can remember back. Okay, let's jump in. All right, so today we're gonna be

talking about types of upside And we're just gonna give definitions definitions of

what types of upside we have, examples of when it's gone well, when it's gone

poorly. So let's go ahead and start with seller financing. What is it and what are

some examples of when it's gone well and when it's gone poorly? Great question. And

like a lot of people, a lot of sellers, so a lot of people listen to this podcast

may be contemplating selling their business at some point. I just realize that I

think some of the last statistics I saw in this, you know, 80 % or it's a really

high percentage of small businesses that sell small to mid -sized have some element

of seller financing involved with the deal. It doesn't always have to be that way

and we'll walk through maybe some of the ways it works and some of the ways it

doesn't but basically it's where you are a piece of the structure if you're selling

your business, let's say you sell your business for $5 million and they're coming to

the table with, you know, 2 million of equity, they've borrowed a million in debt

and there's 2 million in debt and there's another million sliver out there, they may

ask if you want to sell or finance that at a certain term or a certain rate for

a certain amount of time. So, it can go really well, it can be a really good

thing. There's a lot of limitations with it, which we can kind of get into when

you start doing it. It depends on if it's being financed, if it's an SBA deal,

they have limitations on what can happen to that, how quickly that piece can get

paid off. So it really takes either an advisor who really knows how to structure

that or a bank that's being really upfront about how they can structure it and what

position you're in and so I mean in a nutshell that's what it is and we can get

into other things if you want but that's in a nutshell that's what it is. The

upside to doing seller financing is one it's really for the buyer but also if

you're going to wait more or a longer time to get your what you're actually selling

then the purchase price is probably going to increase. You know maybe maybe Maybe

maybe not, but it more than likely will and then I mean there might be a component

of an interest rate,

you know, it gets a little fuzzy there, you know, it may or may not have an

interest rate, but there might be some upside with that and so that's, it's mostly

used as a form of funding less or for upside, but it can have some upside.

- All right, so what are some examples of when seller financing has gone well and

when it's gone poorly?

- Well, when it went really poorly was one of our own deals that we did. And we

kind of knew going in, it was gonna be a, it was really about the only way the

deal could get done. And we covered what we needed to get out of the deal on the

front end for the most part. So we knew that this would be a little extra. And we

knew that the, yeah, we just thought that would be a better way to do it 'cause

we wanted the deal to get done. We really didn't want to be managing this business

anymore. So we did that and over time, they kept piling on senior debt in front of

us. And then they went belly up and that was a deal went bad.

We never, I mean, we got payments for a couple years, and that was about it. And

so, you know, going in, I think there has to be these eyes wide open thing going

in. But most of the time, that's very unusual, because most of the time, you know,

we knew the risk going into that as a pretty high risk deal. So we kind of knew,

like I said, most of the time, it's not that it's not that risky. And you and you

it's, it's all in how it is, it's structured. So you want to make sure you don't

have too many layers of financing above you. Most owners don't like it because

there's going to be senior debt in most cases and they're going to be secondary.

There's not a bank out there who's going to lend senior money at the good rates

that's going to have a loan in front of them. And that's the way most owners would

like it, but they just didn't happen that way. But you bet you can protect

yourselves in some other ways. You can put some clauses in there. So if there's a

sale, you know, it's paid off. There's, you know, if you're dealing with SBA, you

have to kind of watch it because SBA only allows subordinated loans to be paid off

at a certain pace, or they can't be paid off in some cases before their loan is.

And so, but, but you can also use this really creatively. And this is where I

think we've really learned through the years to make it creative. On one of our

other deals that did work out, well, we tagged on some seller debt. We kind of

need it up front. We got on the seller debt side, but we tied it to an earn -out,

and I know we're going to get to earn -outs here in a minute, but we actually tied

it to an earn -out where if we didn't make the earn -out, instead of it, it just

came off the amount of the note, off the principle of the note. It worked out

well. It was one year we didn't make the earn out, but the other years we did.

And so, you know, it all panned out. The other thing you can do that makes a deal

worthwhile with this is that in most deals, there's a hold back. And so those who

are listening, say you sell a deal for $10 million, it would not be unusual for

there to be a million dollar hold back. They're gonna take a million dollars and

it's gonna be put in escrow, or they're gonna owe that in a certain amount of

time, typically one or two years. Sometimes you can kind of make that in different

tranches along the way that's paid back. But what you can do, instead of having a

larger, if you've got seller financing, what you could do instead of having a

holdback or a large holdback, you can tie the indemnity claims. So holdback is in

case you have an indemnity Again, it's anything you've indemnified the seller for and

then, excuse me, even the buyer for. And so let's say you have an indemnity claim

that would come off of your seller note rather than having this hold back. So there

are some creative ways to use a seller note that can be effective and useful for

both parties. And that means you would get more of your funds up front by not

having the hold back. Yeah, and, and honestly, And honestly, you guys have learned,

Dave, you and Grant have learned kind of the hard way in some cases,

right, for self -financing. And to be honest, in the last few years,

it really, I have not seen any, I can't recall anything that has gone poorly as

far as self -financing goes. And I think that, look, seller financing, it's mostly

straightforward. Obviously, like Dave mentioned, you can be pretty creative in things,

but it's pretty straightforward and so I know most of our clients,

especially kind of in that sub $5 million businesses,

if there's a certain amount of seller financing, then the question is,

how do you secure it? What happens if they don't pay it? All those questions really

arise and look at at the end of the day, it's their choice if they want to

actually finance the deal. And one of the points that you made was we wanted to

get out of this deal And we wanted to stop managing this business, and so we

financed. And that's the case for a lot of people,

but it is the seller's choice. Yeah, the motives are different. And the other thing,

I think, we can talk a little bit about rolled equity, but rolled equity is one of

those-- we've seen more rolled equity in recent deals than we have seller financing.

And rolled equity is a way to take seller financing and turn it into equity. So

let's just use real life example.

We have, you sell a $10 million company and you own 100%.

Well, you want to, just say your trend is really good. So your sales are going up

and here you are, you've decided to sell and you're having a banner year, but you

haven't realized those realize those gains yet, but you being the very prideful

business owner that you are, you want to be paid for those gains, or you want to

be paid for, hey, this has got to keep up next year. So one way you can share in

that is to roll some of your equity. And this is really big in the private equity

world. They love it. Most of them love it when an owner will roll their equity.

And they're just basically taking an equity position in the new company. Instead of

getting paid, say $2 million, they're taking 20 % of their equity and they're

becoming a 20 % equity partner in this new deal. And it can work. Maybe Andrew,

maybe explain a little bit about the platform, how that works on platform versus,

you know, a tuck in later on. But platform is where you kind of want to be

involved with that, I think, in most cases. Yeah. So, rolled equity examples of when

it's gone well, when it's gone poorly, have you been involved in the deal yourself

with rolled equity for one of y 'all's businesses? Yes. Yes, we are. And we're still

in the process. We'll see what shakes out with it. I mean, it was a company that

was bought by private equity and we believed in them. Our main person who was

running our company stayed with them, so we believed in him as well. Again, we

believe even management. So in that particular case, we did, we collectively as a

partnership decided that we would roll 20 % into the next deal. And here's why we

wanted a second buy to the Apple. We were content with what we got for the

company, but we figured these guys are going to go on and they're going to use our

company as a platform company. And then they're going to start buying other companies

and putting them underneath it. And so we So we did some protections on it to

where we were always going to be in a good position because it's a platform

company. We would keep the same position as some of the original equity holders,

which was important. And as they tuck in, you know, we hope that someday they'll

sell that, you know, their plan was a five to seven year plan, we're probably four

years into it. You know, they'll sell it someday, we hope. And we'll get a second

buy to the Apple, if it sells for, you know, with a profit, we'll get that 20%.

And so it was worth a test because, you know, we believe in where it was going to

go. And it was a way for us to make a future investment. And we have nothing to

do with the management of that business. We have nothing to do with it. I mean, it

really, it's two scenarios. Are you going to stay involved with the company or are

you not? And you guys did not. But at the same time, while you trusted the

company, you trusted the general manager of that company and the way that he was

projecting it or directing it. I think that that's key because there are times where

that's a big part of why a buyer wants to use some rolled equity.

He has to fund it, but really

They can trust that the seller is kind of putting his money where his mouth is,

right? And that he's keeping money in the company and investing it alongside them

and showing that he believes in the company and not to succeed on its own.

And, you know, it on the flip side if they staying in there it's also a great way

for the buyer to solidify the seller's commitment to the company maybe is staying on

and so it's it's really situational and i know i can recall a time where where you

know client of ours he was rolling 30. I can't remember exact numbers 30 % will

call it

Over to the new new company or the new co is as it's called pop by popularity but

it's it's he wasn't necessarily going to stay with the business and and there was

some you know his his his general manager kind of bought in a little bit and so

he rolled his his equity and and Over and so And so, it was really a way for the

GM to be on the same side of the table as not only the buyer,

but also the seller that's rolling equity. Because if the seller and the buyer don't

know each other, how can he trust the company to do well if they're not controlling

it anymore? Right. Especially if they haven't had any experience in this particular

business, right? - Exactly, exactly. So there's, look, there's so many ways you can

treat rolled equity, but you're right. Being a platform though, that's gonna be

mostly when it's used and the reason is because you can,

you're selling at an X amount and hopefully it'll grow. And unfortunately this has

And in fact, actually, we've recently covered this kind of offer that a client had

received where they received the actual enterprise value of the company per this

offer was about 20 million. And the seller is getting about 13 up front. He's

rolling 40 -something percent. But the buyer proposed that the company would grow from

a 4 million EBITDA company to an 11 million EBITDA in just a few years and so

they would sell then at a greater multiple and they proposed that the seller was

going to get a total of over 50 million or something like that of the combined

initial and second transactions. The problem was that it didn't that's how they were

going to grow the company. They grew by acquisition. Then the percentage,

the role equity percentage was going to go down if he didn't provide any capital

for that acquisition. Yeah. And so the buyer had historically a hands -off approach

to the operations. And so, so, you know, you have, we had to to ask the questions,

"Well, if you're going to be running the company, why aren't you already achieving a

million, 11 million in EBITDA already?" Well, this company had been going for several

decades, right? And they were, it's a great company, but it's still, you know, you

have to, yeah, it's a little bit - Our client didn't see the 20 million. They saw

the 50 million as a purchase price. And this is absolutely why you have to,

you know, it's why that kind of proposal is dangerous, but and why you need to get

somebody in the room that has that experience with this kind of verbiage, enough to

negotiate some of those things in there and or just even flat out tell you that

hey don't take the offer. You know that's a perfect example of a, you know, and

this is not a slum of private equities, Sometimes you've got to remember a lot of

private equity companies have never, they may be on their first platform or second,

but they've never been in the trenches owning their own business necessarily. They've

owned them maybe from a high level or they've got, you know, they've hired guns

going in. And I think a lot of advisors are in the same position. I think one of

the advantages we do have I think with the ICCG is that Grant and I have owned a

lot of businesses three years and we've really screwed up in some circumstances.

We've learned the hard way, and we would never do that way again, and so our

clients benefit from that, because we would never do that for them again. But that's

a great example, Andrew, of you can make a spreadsheet, say whatever you want to

say. I can-- the pie is the sky out there, but there's a reality to the reality

check that comes along with that that's really important. One thing I wanted to

point out about the roll equity, which is a little unusual and one of the deals we

did it may be the one you're referring to prior to this one Andrew was we I think

this person had sold some of their equity to the general manager which was a great

idea because then he was able to roll his his equity in and and they the buyers

wanted that they almost demanded that because it kept him bought in right but the

unique thing about that particular situation is they came in with little debt. And

what that allowed them to do is make distributions. And so actually the role equity,

they're making distributions at least once a year for any profit that comes through

the business. And so that was a really unusual situation. All that to say, every

deal is structured separately and differently. - Yeah, that's great. Earlier you

mentioned an earn out. I just wanna go back to that and what is it, and what are

some examples of when it's going well? You know, earnouts are based on different

things, and it's really hard to say this is an earnout. But basically it's this,

you're tying a seller to where they can receive an earnout.

They can receive additional funds as the business performs certain KPIs or whatever

so to say and we we'd like to tight if to revenue at all possible because you

know a seller may have some influence on how they introduce customers to the new

people you know they may have they may be able to influence customers to keep

buying from that particular person let's say it's a manufacturing company and you

know they may have those relationships that they can help continue on. Where they

lose control, those with the cost. And so a lot of people want to tie it to the

bottom line, which isn't a bad idea, it's just the seller has no control over that,

has the least amount of control. Not that they have control over the revenue, but

again, we did one up here up in the Northwest that was a home service business And

he'd had really consistent sales, and so they said, "I'll tell you what, for the

next two years, if you hit just the same sales figure that you hit last year, if

you feel that positive that we're not going to lose any customers and we're going

to keep going, because that's really the biggest concern. We're going to lose

customers when we change ownership. We'll pay you whatever the number was, $100 ,000

each year for the next couple of years." And I think he made those earnouts in

both times. So there's different ways to do earnouts. Most people don't want to it's

too they think it gets too complicated. What we tell people is let's keep it

simple. Let's see if we can come out with something. It works really well if you

have it. It shows the confidence that a seller has in their business. I get a

little squeamish of a seller who's like no, no, no, I don't want anything to do

with an earnout. I don't even want to talk about it. I'm thinking well, but you

just told me how great your business was and how your trending is up and you

believe in what you're doing, but all of a sudden now you don't. So, you know,

there's kind of pros and cons there. And even one of the cons, you know, from the

buy side is that, I mean, a buyer is going to say, okay, I mean,

especially if the seller might have a little bit of more control, control is a big

piece, right? They lose the big con for a seller is that they lose control or they

may or may not lose control of how the performance is in the company. And so even

on revenue, if I'm selling my company and my landscape company and I don't have any

more control but I tied to an earn out, can I trust him to market the company

well, to do, you know, to grow it, you know, or else I'm just going to, I'm not

going to get anything for it, you know. And so, you know, it's kind of, it's,

that's where it's kind of tough. Now on the flip side, on the buyer, if he

remains, then you really, you know,

are they going to try to just cut costs so that they can get more sales,

but I'm not going to earn anything, you know, anything out of it. I'm a bottom

line. And so we, one of the, this was kind of a specific scenario that we just

had with, we received an offer for, for a company and we didn't end up taking it,

but essentially the way it was structured was there was an earn out.

If he hits this amount, then he gets a certain portion of the certain percentage of

the sales. And as long as the gross profit was greater than or it hit a certain

level, right? A certain 30 % or whatever it was, 40 % or whatever it was,

and that ensured that they were going to not only have money in the bank to pay

him that 5 % or 2 % or whatever it was of the sales, but it also allowed them to

secure some bottom line for them. And he was involved with the sales of the

company, the marketing And so that was a that was a unique way. I just thought

that that was a good way to structure it All that to say again It can get as

creative as you need to be just make sure that if you start dabbling this you've

got people alongside you Who can get creative with you and you've got a good

attorneys or? Advisors who are advising and giving good advice to protect you in it

Yeah, Absolutely. Well, that's all we have for today. Thanks for tuning in, and

we're going to dive deeper into these types of upside and deal components in a

future episode, so stay tuned.

And that wraps up another episode of Integrated Insights with ICCG. Be sure to

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