Private Equity Sellers Turn to Earnouts and Seller Notes to Seal the Deal

As the old saying goes, “where there’s a will, there’s a way.” In the increasingly challenging world of private equity deal financing, sellers are discovering that willpower – and some creative financing solutions – can go a long way in closing transactions.

Dealmakers are finding themselves in a financial limbo as economic uncertainty and tighter debt markets widen the valuation gap. But worry not, for humans are nothing if not resourceful. Enter earnouts and seller notes, two clever mechanisms designed to bridge this gap and bring buyers and sellers closer to agreement.

Earnouts, the financial equivalent of “I’ll pay you later,” allow buyers to defer a portion of the purchase price and make the remaining payments only when the purchased company achieves certain milestones.

Last year, 21% of private mergers and acquisitions in the US contained earnout provisions, up from 17% in 2021, according to SRS Acquiom. Furthermore, 18% of M&A deals involving private equity buyers had earnouts, up from 15% the previous year.

Seller notes, on the other hand, are IOUs from the seller to the buyer.

In these arrangements, the seller agrees to receive a portion of the acquisition proceeds as a series of debt payments. While these notes carry more risk than senior debt, they typically have a lower interest rate than mezzanine debt. They may not be a one-size-fits-all solution, but they’re certainly making an appearance in today’s deal-making landscape.

So why the sudden popularity of these financial tools?

Well, one reason is to bridge the infamous valuation gap. Buyers and sellers often have different ideas of what a company is worth, thanks to the unpredictability of interest rates and economic outlooks. Earnouts and seller notes help make everyone feel a bit more comfortable with these discrepancies, like financial yoga for deal-making.

However, these structures aren’t a free lunch. “Earnouts and seller’s notes are not free money; they are real debt on the business as someone has to pay the contingent payments when they are due,” said Reed Van Gorden of Deerpath Capital. Buyers and sellers must be prepared to pay their dues when the time comes.

Kip Wallen of SRS Acquiom expects these structures to remain popular if market conditions continue to be unfavorable. “If deal activities start to take off, we might start to see sellers have more negotiating leverage and we will see fewer earnouts and fewer seller notes,” he said. “But if we don’t get that hockey stick moment, we will continue to see buyers make headway in that area and those types of deals tick up.”

In conclusion, as the private equity market continues its high-stakes game of financial Twister, dealmakers are turning to earnouts and seller notes as creative ways to close deals. These innovative solutions may not be a panacea for all market woes, but they’re certainly adding some much-needed flexibility to the deal-making process. So, keep calm and carry on negotiating, for where there’s a will, there’s a way – and apparently, an earnout or seller note too.

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