Earnouts, rollover equity and seller notes

Key takeaways

• Earnouts bridge a valuation gap by making part of the price contingent on future performance; their design (metric, period, threshold, cap and the buyer's operating covenants) decides whether they pay.
• The value of an earnout is the probability weighted payout, discounted at a rate that reflects its risk; in the Tamsin example a $40m earnout is worth $18.0m expected and $13.6m in present value.
• Rollover keeps sellers and management invested alongside the sponsor and, when properly structured, can defer tax on the rolled portion; it is equity risk, priced at the same entry valuation as the sponsor's.
• A seller note is deferred price lent to the buyer, deeply subordinated to the acquisition lenders, often paying in kind; it should be valued as junior credit, not at face.
• A $360m structured headline can be worth $329.5m in present value, which still beats a $310m all cash offer on expected value but carries risk the cash offer does not.

Why structure appears: the valuation gap

A valuation gap usually comes from one of three disagreements. The seller expects growth the buyer will not underwrite, often because a new contract, product or site has not yet shown up in trailing earnings. The seller believes the business is lower risk than the buyer does. Or the two simply hold different views of the multiple. The first two are about the future and can be bridged by tying payment to what the future turns out to be.

Each tool moves a different risk. An earnout moves operating risk: the seller is paid only if a metric is hit. A seller note moves credit risk: the seller is paid later, if the company can pay. Rollover moves equity risk: the seller's retained stake rises or falls with the buyer's. A buyer offering all three is asking the seller to finance part of the deal and to bet on the plan.

Designing an earnout

The metric comes first. Revenue is hard to manipulate and easy to measure, which sellers prefer, but it pays for growth without regard to profit. EBITDA aligns better with value but depends on the buyer's cost allocations, integration decisions and accounting choices after closing, which is where most disputes start. Non financial milestones, such as a regulatory approval or a contract renewal, suit businesses where one event drives value.

The period is typically one to three years. Longer periods lift the seller's risk and the chance of a dispute, because the business will have changed under the buyer's ownership. Payouts can be all or nothing at a target, or scale linearly between a threshold and a target, with a cap. Linear schedules are less brittle: a near miss does not turn a large payment into nothing, which removes much of the incentive to fight over a few hundred thousand dollars of EBITDA.

Disputes are about control. The seller wants covenants that the buyer will run the business consistently with past practice, fund the plan, not divert customers to its other companies, and keep separate books. The buyer wants freedom to integrate and run the company as it sees fit. US courts generally read earnout obligations narrowly, so a seller who wants protection must write it into the agreement; the implied duty of good faith will not supply much. Agreements usually send accounting disputes to an independent accountant and also address acceleration of the earnout if the business is sold again.

Rollover equity: management and sellers

In a sponsor buyout, the founder or selling owners and the management team often reinvest part of their proceeds in the new holding company that owns the business. For the sponsor, rollover reduces the cash equity it must write and keeps the people who know the business invested in the outcome. For the seller, it is a second bite: if the sponsor's plan works, the retained stake may be worth more at exit than the cash taken today.

Rollover is usually priced at the same valuation as the sponsor's equity, so the seller buys in at the deal price. A seller rolling $30m into a holding company with $150m of total equity owns 20 percent alongside the sponsor's 80 percent, before any management incentive pool. The terms that matter are whether the rolled equity is the same security as the sponsor's or a junior class, the governance rights that come with it, tag along and drag along rights on exit, and whether management's rolled shares are subject to leaver provisions.

The tax idea, at a high level: in the US, a properly structured rollover can let the seller defer tax on the rolled portion, because exchanging an interest in the target for an interest in the buyer's holding entity can qualify as a nontaxable contribution (for example to a partnership under Section 721, or to a corporation under Section 351). The seller is taxed on the cash received and carries the rolled interest forward at a low basis until exit. Whether a given structure qualifies depends on the entities involved and requires tax advice; it is the reason rollover holding companies are often partnerships for tax purposes.

Seller notes and where they rank

A seller note is part of the purchase price paid later, under a loan from the seller to the buyer. In a leveraged buyout it sits below the acquisition debt: senior lenders require a subordination agreement under which the note is not paid in cash while senior debt is in default, its holder cannot accelerate or enforce for a standstill period, and its maturity falls after the senior debt matures. In the stack it ranks behind every lender and ahead only of equity.

Because cash payments are constrained, seller notes often pay interest in kind, adding it to principal, with a bullet repayment at maturity or on a sale of the company. The coupon looks like debt, but the risk is closer to junior mezzanine. A seller should value the note at a discount rate reflecting that ranking, and ask for protections such as acceleration on a change of control and limits on further debt ranking ahead.

Buyers like seller notes because they are cheaper than equity and lenders often treat them as quasi equity when deeply subordinated. They also give the buyer a source of recovery: many agreements allow indemnity claims to be set off against the note, which makes it a form of security for the warranties.

Worked comparison: all cash against a structured offer

Two bidders compete for Tamsin Labs. One offers $310m in cash at closing on a cash free, debt free basis. The other headlines $360m: $270m cash, $30m rolled into the new holding company, a $20m seller note and the $40m earnout valued above. The headline comparison says the structured bid wins by $50m. The present value comparison is the one that counts.

The rollover is valued at face because it is bought at the same price as the sponsor's equity; it is still at risk, which a seller with all its wealth in the business should weigh. The note is valued as junior credit at 12 percent. The earnout is valued at its probability weighted present value.