Advisor Acquisition Loans And Earn-out Structures
An earn-out structure is where the buyer usually pays a portion of the purchase price as a down payment and the rest is paid out contingent on post-acquisition financial performance. Either a percentage of revenue or NOI is typically paid to the seller over a set period of years, or until the agreed upon amount is paid out.
A seller may want an earn-out structure if they have a high growth business where they strongly believe the value of the business exceeds what a business valuation will represent. Earn-outs are also more popular structures when the buyer is paying out of pocket cash for the down payment.
In wealth management M&A, when a bank loan is involved, an earn-out structure is where the buyer gets a loan for the down payment (for example 50% to 75% of the purchase price) and the rest is received by the seller contingent on future performance.
Earn-out structures are more common for smaller deals when bank financing is not involved and for larger purchases over $5 million. For acquisitions between $250,000 and $5 million that we see, earn-out structures are not nearly as common as seller promissory notes or escrow disbursement provisions.
This article covers earn-out structures specifically in wealth management M&A and from the context of when bank financing is needed for the down payment.
Earn-outs involving conventional and SBA loans
Conventional loan - As long as the projected earn out terms cash flows, most conventional lenders accept earn-out structures. From a lender’s perspective, earn-outs provide some short-term protection for their borrower from a significant downside turn in revenues after the loan closing. And, as with a seller promissory note or escrow agreement provision, earn-outs provide some protection for higher than anticipated attrition. Also similar to seller financing, earn-outs provide the lender with a low LTV, while still being in first lien position with the earn-out subordinated to the lender.
SBA loan - The SBA prohibits earn-out structures. Earn-out promissory note structures are not allowed in SBA lending. If it looks like, or smells like a “revenue share” arrangement, the SBA lender won’t approve the purchase agreement. If a seller is set on having an earn-out structure and the buyer needs a bank loan for the down payment, they will need to qualify for a conventional loan.
Earn-out Note Subordination
In virtually all cases, our lenders require that the earn-out note be subordinated to the lender. This means the seller is in second lien position behind the lender. Lenders create their own subordination letters that the seller must execute in order for the buyer to close and fund the loan. In addition, most subordination letters will also give the bank the right to pause the buyer from making earn-out payments if the buyer is struggling to make the bank note payments.
More complicated legal and tax considerations
Earn-out structures need to be carefully considered and constructed. There are serious tax implications if the earn-out is conditioned on future services by the seller (viewed as compensation and taxed as regular income) instead of a deferred purchase price payment (taxed as capital gains). Borrowers should use experienced professionals with specific expertise in advisor acquisition agreements and terms, but even more so when earn-out structures are being used.
When seller is retiring during the earn-out term
If the seller is going to retire during the earn-out term then the lender’s lawyer reviewing the deal will want to make sure this is accounted for in the purchase agreement language. Depending on the advisor’s model and affiliation, different rules apply to a buyer paying part of the revenue the practice earns to an unlicensed individual.
Custodians usually allow for this by the seller qualifying as a “solicitor” allowing for ongoing payments when not licensed and simply disclosed to clients during the transition process. While most independent broker dealers (IBDs) are “earn out friendly” there are IBDs who are not. Some IBDs have strict compliance rules around ongoing revenue share between affiliated advisors with unlicensed individuals.
Advisor acquisition earn-out structures are typically always embedded into the purchase agreement as a future payment of the purchase price. Even so, some IBDs dismiss the purchase agreement language and take the stand that if it looks and smells like a revenue sharing arrangement then it should be treated like one. Advisors should check with their IBD and custodian early in the process to determine and account for their earn-out requirements when the advisor is retiring during the earn out term.
When seller is continuing to work throughout the earn-out term
If the seller is going to continue as a licensed advisor throughout the earn-out term then there are fewer hoops to jump through. While most IBDs allow for it, there are IBDs who will not allow the advisor buyer to pay the selling advisor directly through earn-out payments, even if licensed. Some IBDs will require that a team ID rep code be established with the IBD paying 60% of compensation to buyer’s rep code and 40% to the seller’s rep code for example.
Buyer pre-qualification even more important with earn-outs
For any acquisition loan, it’s just smart for buyers to get pre-qualified for the loan amount and deal structures they can target. But, this is even more critical when an earn-out structure is going to be involved.
We’ve seen a few acquisition deals fall apart when the buyer and seller agreed to an earn-out structure before the buyers went through the step of getting pre-qualified for an acquisition loan. They had their agreements already drawn up, acquisition date set, and then went to get their loan. In these specific cases, each qualified for an SBA acquisition loan (which doesn’t allow for earn-out structures) but not for a conventional bank loan.
In one case, the seller was set on the agreed upon earn-out structure that could not be accomplished with that specific buyer. While the buyer offered a reasonable seller note compromise the seller was unwilling to change the structure and selected a different buyer who qualified for a conventional loan. In the other two cases the loans did close but not without delays and frustration from the back and forth restructuring.
If the buyer is going to need external bank financing for the down payment, then the buyer will need to be strong enough to qualify for a conventional loan. If the buyer doesn’t qualify for a conventional loan then the down payment can’t get financed through a SBA loan.
Earn-out workarounds
Earn-out structures are more complicated, and by their nature the end results are more contingent based. These structures are not allowed in SBA lending, and are not allowed by some broker dealers. Sometimes the only solution to completing an acquisition deal will involve an earn-out structure. However, generally, there are acceptable alternatives advisors can utilize other than an earn-out structure to get the deal done.
Seller promissory notes and escrow agreements can be structured over multiple years and based upon clawbacks for revenue attrition. For SBA loans, a premium price can be agreed upon with any difference in the business valuation and purchase price covered through a seller note. Instead of the seller receiving a percentage of revenue in an earn-out, they can receive a set dollar amount that is then reduced if revenue doesn’t hit a predetermined benchmark.
If the buyer will be utilizing an SBA loan for the acquisition, the ongoing payments must be structured where the seller can not receive more than the original purchase price. The sum of all the payments made through a promissory note or escrow agreement can’t result in the seller receiving more than the originally agreed upon purchase price. The total amount paid can go down (protecting the buyer) but can’t go up.
Call us if you would like to discuss the impacts of an earn-out structure for your specific acquisition and scenario, or how alternative payment structures could be designed that wouldn’t prohibit bank financing for the down payment.