Why do vendors (with an equity roll) accept earnouts being paid out of the company's cash?
Asked my SVP about this and he told me that this is just how it's done, however, when thinking through the theory of it it doesn't really make sense.
An earnout is structured to provide additional payment to the vendor if the company performs well and hits certain targets. If, at the time of the purchase of the company, a buyer was sure that the company would hit those targets, it would pay the earnout amount in up-front proceeds. The uncertainty results in purchase considering being deferred and contingent on future results.
If a vendor rolls equity, however, it has rights to the cash flow generated by the company equity to its ownership post-transaction (cash which would be distributed through dividends, pay down additional debt, reinvested in the company etc.). Paying an earnout from the company's cash flow effectively pays the vendor for the initial transaction with cash to which the vendor already has right to after the transaction. The impact is the same if additional debt is taken on by the company to pay the earnout - cash that the vendor has right to will be used to repay the debt.
Why isn't an earnout either paid through 100% additional equity injected by the sponsor or structured in a separate entity where the sponsor can take on debt to pay the earnout and then repay the debt with its portion of cash distributions from the company?
Any form of seller financing whether done via earnout or a seller's note is always a big win for a buyer for obvious reasons.
And you're correct, it's a term you probably don't want to see as a seller.
Simple answer is: because they also share in the upside (for their rollover %) that the company has become worth more. If they would have wanted all cash offer, the purchase price would have been lower. This is a method to bridge the information asymetrie and differing views on growth potential of the company.
But the vendor shares in the upside through the equity roll. At the time of sale, the vendor presented a forecast that it believed would be reached and wanted to get paid for it - because the buyer didn’t think so and deferred payment shouldn’t mean that vendor now has to fund a portion of their own earnout, on the contrary the sponsor should pay the earnout from its funds in full as it would have if there was more certainty in the forecast at the time of the purchase.
Look at it this way. NewCo acquires target A. The sponsor funds 60% of equity ticket and Vendor A funds 40% of the equity. Now an earn-out becomes payable: sponsor funds 60% and Vendor funds 40% of earnout > result is that Vendor pays 40% of its own earn-out.
If you don't fully sell the company, you can't be entitled to 100% of a component of the Enterprise Value like the earn-out. In case you would have received a full cash offer but rollover 40%, you would also only receive 60% of the equity value.
That clarifies it, thank you!
Other consideration is that if you're trying to require your earnout to be paid by an equity contribution, you're either getting diluted (reducing your future equity value) or immediately kicking back in your pro rata share which is suboptimal if you're trying to take chips off the table.
Rover-S gave a good answer. Another way to think about it is: The Seller is also a buyer. Pretend the Seller sold 100% of the company and the PE firm bought 60% and the Seller bought 40% from him/herself. Any earnout payment would go 100% from the Seller but need to come 60% from the PE fund and 40% from the Seller. It sounds silly, but sometimes this is what is actually technically happening.
If your Senior VP’s answer was: “This is just how it’s done” ... the Senior VP was either blowing you off or, more likely, doesn’t fully understand it him/herself.
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