About Advisor Acquisition Earn-out Notes

An earn-out is a form of seller financing and a payment structure commonly used in financial advisor acquisitions although less and less for numerous reasons this article will cover. Advisor earn-outs are different from revenue sharing and typically involves the buyer making an upfront partial payment, with the remaining amount earned out contingent on the financial performance of the acquired business post-acquisition. Typically, a percentage of revenue or net operating income (NOI) is agreed upon and paid to the seller over a specified timeframe or until a predetermined amount is reached. This structure is often favored by sellers of high-growth businesses who believe their business's value exceeds traditional valuations. Earn-outs are particularly popular when the buyer and seller have a strong relationship, and the buyer may have difficulties qualifying for a bank loan.

Earn-outs are the most complicated type of acquisition payment structure with the most moving pieces to account for. There are compliance, tax and bank loan factors to address if an earn-out structure is something you’re considering. Lets go over the key issues regarding earn-out notes in advisor acquisitions.

Navigating Complex Legal and Tax Considerations
Earn-outs typically involve more intricate legal structures compared to other payment arrangements. They require detailed terms and conditions based on future performance and can include various provisions, such as revenue targets, financial milestones, or clawback clauses for revenue attrition. The complexity lies in defining and agreeing on specific metrics, timelines, and conditions to determine earn-out payments. Additionally, legal documentation is essential to outline the earn-out terms, including the calculation method and the rights and responsibilities of both buyer and seller.

Earn-Out Note Subordination
In most instances, the earn-out note must be subordinated to the lender when a bank is involved in the transaction. This subordination means that the seller’s right to receive earn-out payments is secondary to the lender's rights and repayment priority. Such a framework ensures that the lender has the first claim on the borrower’s assets and cash flows, including any earn-out payments, in the event of default or financial difficulties. This arrangement is akin to the way a seller's promissory note would also be subordinated to the interests of the lender.

When the Seller Retires During the Earn-Out Period
If a licensed financial advisor sells their practice and retires during the earn-out term, it is crucial to address this scenario within the purchase agreement. The seller's retirement may affect the earn-out structure's terms and conditions. Typically, the lender's attorney will seek to ensure that the retirement is clearly articulated in the purchase agreement's language. Depending on the advisor's model and affiliation, varying rules and regulations may apply regarding a buyer paying part of the practice's revenue to an unlicensed individual, such as a retired seller. Custodians often facilitate this by qualifying the seller as a "solicitor," allowing for ongoing payments even if the seller is no longer licensed.

Understanding How Rule 2040 Affects Advisors Selling Their Practice and Retiring
When a licensed financial advisor decides to sell their practice and retire, it’s crucial to navigate the regulatory landscape to ensure they receive their fair share of the sale proceeds. FINRA Rule 2040 provides a solid framework for this transition, allowing for compliance with federal securities laws while enabling retired advisors to continue receiving compensation under certain conditions.

Under Rule 2040, a retiring registered representative can still earn commissions from accounts maintained for ongoing clients. This is allowed as long as a bona fide contract is in place, established while the advisor was still active, which outlines the terms for ongoing payments. Importantly, the contract must explicitly prohibit the retired advisor from soliciting new business, opening new accounts, or servicing existing accounts that generate these commissions. This requirement helps ensure that the retired advisor stays in line with federal securities laws and FINRA rules.

For the arrangement to hold up, the advisor must sever their ties with the member firm and exit the securities industry. However, the contract can include provisions for continued payments even after the advisor's passing, directing these payments to a designated beneficiary or the advisor’s estate.

When the Seller Continues to Work During the Earn-Out Period
If the seller of a financial advisory business remains licensed throughout the earn-out term, complications typically decrease compared to a scenario where the seller retires. In this case, there are generally no issues with the seller continuing to receive earn-out payments directly. While most Independent Broker Dealers (IBDs) allow such direct payments, it is essential to recognize that certain IBDs may impose specific rules and compliance requirements. Some IBDs may require the establishment of a team ID representative code, where a portion of the compensation is allocated to the buyer's rep code, while the remainder is directed to the seller's rep code.

Buyer Pre-Qualification is More Important with Earn-Outs
When an earn-out involves a bank loan, the buyer must be financially strong enough to qualify for a conventional loan to cover the down payment. Earn-outs are not eligible for SBA acquisition loans, so if the buyer doesn't meet the criteria for a conventional loan, they may struggle to secure financing for the down payment, jeopardizing the entire deal. By completing the pre-qualification process for an acquisition loan in advance, buyers can determine the loan amount they can target and assess feasible deal structures. This proactive approach helps prevent scenarios where buyer and seller agree on terms and set an acquisition date, only to discover the buyer doesn't qualify for necessary financing.

Earn-Outs Involving Conventional and SBA Loans

Conventional Loans - Most conventional lenders accept earn-out structures as long as the projected cash flows align with the earn-out terms. From a lender's perspective, earn-outs offer short-term protection for borrowers against significant revenue declines after loan closing. Similar to seller promissory notes or escrow agreement provisions, earn-outs also safeguard against higher-than-expected attrition. Furthermore, akin to seller financing, earn-outs provide lenders with a low loan-to-value (LTV) ratio while maintaining a first lien position, with the earn-out subordinated to the lender.

SBA Loans - The Small Business Administration (SBA) prohibits earn-out structures. Earn-out promissory note arrangements are not permitted in SBA lending. If an arrangement resembles a “revenue share,” the SBA lender is unlikely to approve the purchase agreement. If a seller insists on an earn-out structure and the buyer requires a bank loan for the down payment, they must qualify for a conventional loan.

Earn-Out Workarounds
When utilizing an SBA loan, traditional earn-out structures are typically prohibited. However, there are alternative strategies that can achieve a similar effect. Instead of relying on an earn-out framework, advisors can consider these workarounds to facilitate the deal:

1. Seller Promissory Notes: The seller may issue a promissory note that allows payments to be spread over several years, with the amount adjusted according to revenue performance. This arrangement enables the seller to receive payments over time, contingent upon the business's success.

2. Escrow Agreements: Like seller promissory notes, an escrow agreement can be designed to distribute payments to the seller over a specified period. Clawback provisions can be included to address potential revenue decreases.

3. Premium Price with Seller Note: The buyer and seller may agree on a premium purchase price, with the disparity between the business valuation and the purchase price covered through a seller note. This allows the seller to receive a fixed amount over time, adjusted based on established benchmarks.

These workaround strategies can provide effective alternatives for navigating the constraints of SBA loans while still ensuring compliant structures.