As websites and online businesses become more popular, the pool of investors has grown significantly. The majority of buyers and investors in the space tend to be individuals, especially for smaller sized transactions below $1 million.
As website valuation multiples have started to expand, and the size of deals are getting bigger. Following this trend, we have seen more and more buyers making offers with unique financing structures, beyond an ‘all-cash’ offer.
The two most popular financing strategies we have seen buyers use are seller financing and earnouts.
On the surface, the two might seem similar, but they are very different. In this post we will cover:
- Seller financing: what it is, and what an offer with seller financing looks like
- Earnouts: what they are, and what an earnout looks like for the seller and buyer
- Seller financing vs. earnouts: the difference between the two
- Pro’s and con’s of each structure for both the buyer and seller
- How to safely structure seller financing and earnouts from the sellers perspective
What is Seller Financing?
Seller financing is when a seller agrees to receive a portion of the sale price in the form of a note, or a series of payments over time rather than upfront. Buyers love seller financing because it requires them to make a smaller cash downpayment, ultimately allowing them to buy a bigger business with less cash.
Seller financing is an obligation from the buyer to pay the seller a guaranteed amount of money over a period of time.
What does an offer with seller financing look like?
Offers with seller financing will look something like this: 80% cash payment at closing, with 20% seller financed over a period of time. The period of time is usually 12-24 months from the date of closing.
Let’s use a $500k business as an example. A buyer offers to pay $400k of cash at closing, with $100k financed over a 24 month period. As a seller, you receive a $400k cash payment upfront, and then $4,167 per month for 24 consecutive months. Sometimes the offer will include an interest rate on the note, to reduce the lost returns from being able to reinvest the capital in the stock market.
Buyers love it because they only have to pay a portion of the purchase price out of their pockets. Assuming the business is cash flowing, the buyer then can use the cash flow from the business to make the monthly payments. A genius strategy that can reduce risk for a buyer and allow them to buy a business that they might not be able to afford with 100% cash.
Pro’s and Con’s of Seller Financing for a Seller
- Provides a recurring stream of income after you sell your cash-flowing asset
- This can help any short-term cash flow issues you might have if your website or business is 100% of your income
- Brings more buyers to the table as it makes the business more affordable
- You receive less cash upfront
- Collecting payments if the buyer defaults can be difficult and costly
- Papering legal documents for this is more difficult than a 100% cash offer
Pro’s and Con’s of Seller Financing for a Buyer
- Allows you to buy bigger websites with less cash
- You can use the profits of the business to pay for the monthly financing payments
- Easier and cheaper to obtain than traditional bank or SBA financing
- You are obligated to continue paying the monthly payment, even if the business fails
- You can be sued if you default and lose the website, and potentially personal assets such as your investments or house
How to Safely Structure Seller Financing for a Seller
The biggest risk for the seller is the buyer not being able to make the monthly payments, and defaulting on the loan. If the buyer defaults, you will have to enforce the note with legal action which can be very costly. If a buyer defaults it’s likely because the business is not performing well anymore. So, there might be little value in taking the website back.
If you receive an offer with seller financing, here is what you should do to reduce risk:
- Require as much financial information from the seller as possible: current income, personal assets and net worth, etc.
- Target seller financing only 20%-30% of the sale price
- Hold the domain name in escrow until the final payment is received so that you can take the business back in the event of default
- Require a personal guaranty, or collateralize the loan with other unencumbered assets such as a house, car, etc.
- Ask for an interest rate on the financed amount. You are losing out on potential investment returns by not getting the cash upfront, so ask for an interest rate to get a make up for this
- Get legal counsel involved to draft the agreement
- Discuss the repercussions with the seller ahead of time in case of default
For a more detailed guide on seller financing, read our post: A Seller’s Guide to Seller Financing: How to Structure a Safe Transaction (to be published soon)
What is an Earnout?
An earnout is a financing structure in which the buyer offers to pay the seller an additional amount of cash, IF the business hits certain targets.
Earnouts are structured based on the performance of the business that is being sold. Earnouts are not a guarantee that the seller will receive more cash at a later date.
These are a great way to bridge the gap between valuation differences. If you, as the seller, think your website is worth $550k, but the buyer only thinks it’s worth $500k, you can use an earnout structure to bridge the gap. In this instance, the buyer might offer to pay you the remaining $50k, if the business maintains an average profit of $x over the next 12-months.
Examples of Earnouts in Business/Website Sales
There are hundreds of ways to structure an earnout, but here are two of the most popular we see. We’ll continue with our example of a $500k business with a $400k cash downpayment.
- The seller will receive 50% of the businesses profits, paid monthly, until the additional $100k is paid
- Let’s say the business is currently making $200k in annual profit. If the business maintains $200k or greater of profitability over the next 12-months, the seller receives a $100k cash payment at the end of the 12-months
- You can also tier this so that you receive 50% or 75% of the $100k if the business only hits 50% of 75% of the profitability target, for example
With seller financing, the seller is taking the risk. Because of this, it is common to receive (or ask for) additional upside. Ie. if the valuation is $500k, the buyer might offer $400k cash, but 50% of business profits paid monthly (or annually) until the seller gets paid $150k.
Remember, there is no guarantee! The business must hit the performance targets, or else the seller may get nothing.
Pro’s and Con’s of Earnouts for a Seller
- Opportunity for additional cash upside if the business performs well
- Can provide additional current income if the business you sold is 100% of your income
- Brings more buyers to the table because it reduces risk for them
- You might receive $0 on top of the upfront cash if the business doesn’t perform
- The seller can sometimes manipulate profitability to make it so the targets aren’t hit
- For example, they start spending $100k a year in paid ads that aren’t profitable, or they hire an SEO agency, or hire VA’s, etc.
- The seller usually has very little influence on the performance of the business
- This results in the seller having to stay involved post-close to ensure the business performs well enough
- Papering legal documents is more difficult
Pro’s and Con’s of Earnouts for a Buyer
- Allows you to buy a bigger business with less cash
- You only pay if the business performs well, and any payments can be made with business profits
- The seller will provide more post-sale support to ensure the business hits its targets
- No cons here for the buyer!
How to Safely Structure Earnouts for a Seller
As mentioned above, the buyer can do things to manipulate the metrics to make sure the targets aren’t hit. There is a lot of seller risk here, so there are a lot of thins to do to safely structure the earnout:
- Agree upfront on a detailed calculation of how the performance targets work. You can structure expenses as addbacks so that any expenses the buyer adds to the business post-close are added back to the profitability, not affecting the performance target
- Exclude things like: interest expenses, hired VA’s/employees, added marketing costs, etc.
- Ask for additional upside, if you are selling your site for $500k, ask for a $550k valuation to add $50k of upside for the additional risk you are taking
- Get a lawyer involved to structure this in the safest way for you
- Ask for a salary or additional monthly payment if the buyer expects you to stay involved post-close
- Make sure you fully vet the buyer and his ability to continue running the business. You want to make sure he has a good track record and knows what he is doing!
The Difference Between Seller Financing and Earnouts
- Seller financing is guaranteed, earnouts are not. Therefore, earnouts are riskier for sellers, but better for buyers.
- Earnouts can have additional upside, whereas seller financing usually does not
- Sellers need to stay more involved in the post-sale operations to ensure the business performs. Business performance doesn’t matter in seller financing
- Buyers can default on seller financing, creating need for legal action. There is less legal risk in earnouts (although there is still plenty)