Buyout Option A - Valuing a Contractor's Business

Structuring the sale agreement is crucial to ensure that both the seller and the buyer feel secure and satisfied with the terms. A well-structured agreement can also align the interests of both parties and facilitate a smooth transition of ownership over the specified period.

Given Information:

Purchase Price: $625,000
Ownership Transfer Period: 5 years
Trailing 3-Year Average EBITDA: $218,671
Projected EBITDA: $306,435

Objectives:

Seller's Goals:
Receive fair compensation for the business.
Ensure payment security over the payout period.
Possibly benefit from future business growth during the transition.
Buyer's Goals:
Manage cash flow effectively.
Mitigate risk by tying payments to actual performance.
Gradually assume control and integrate into the business operations.

Proposed Structured Agreement Components

Down Payment:

An initial payment is made at the time of sale to show the buyer's commitment and provide immediate funds to the seller;

Fixed Annual Payments:

Guaranteed payments are made annually over the 5 years, ensuring the seller receives a base amount each year.

Earn-Out Provision:

Additional payments tied to the business's performance (e.g., EBITDA) exceeding certain thresholds, which aligns incentives, rewards the seller if the business performs well, and protects the buyer if performance declines;

Ownership Transfer Schedule:

Gradual transfer of ownership percentages over the 5 years, corresponding with payment milestones;

Security Measures:

Including promissory notes, personal guarantees, or collateral to secure deferred payments and protect the seller;

Performance Covenants:

Agreements on how the business will be managed during the transition to maintain or improve performance;

Detailed Breakdown of the Structured Agreement

1. Down Payment

Amount: 20% of Purchase Price = $125,000
Timing: Paid at closing.

Benefits:

Seller: Receives significant upfront cash, reducing the risk of deferred payments.
Buyer: Shows serious intent and commitment and possibly negotiates better terms on deferred payments.

2. Fixed Annual Payments

Remaining Balance: $625,000 - $125,000 = $500,000
Base Annual Payment: $500,000 / 5 years = $100,000 per year

Benefits:

Seller: Predictable income stream over the next 5 years.
Buyer: Fixed payments aid in budgeting and cash flow planning;

3. Earn-Out Provision

Structure:

Threshold EBITDA: Set at the Projected EBITDA of $306,435.

Earn-Out Payments:

Year 1:
If EBITDA > $306,435, the seller receives 30% of the excess as an additional payment.
Year 2:
If EBITDA > $320,000 (assumed growth), the seller receives 25% of the excess.
Year 3:
If EBITDA > $335,000, the seller receives 20% of the excess.
Year 4:
If EBITDA > $350,000, the seller receives 15% of the excess.
Year 5:
If EBITDA > $365,000, the seller receives 10% of the excess.

Caps on Earn-Outs (Buyer Protection):

A cap can be set on earn-out payments each year (e.g., a maximum of $50,000 per year).

Benefits:

Seller: Benefits financially if the business performs exceptionally well.
Buyer: Payments are made if the business generates sufficient profits, aligning financial obligations with performance.

4. Ownership Transfer Schedule

At Closing: Buyer acquires 40% ownership.
Year 2: Additional 15% transferred (total 55%).
Year 3: An additional 15% transferred (total 70%).
Year 4: An additional 15% transferred (total 85%).
Year 5: Final 15% transferred (total 100%).

Benefits:

Seller: Retains partial ownership initially, ensuring involvement and possibly influencing performance positively.
Buyer: Gradual increase in ownership allows time to adapt and assume full control responsibly.

5. Security Measures

Promissory Note: For the deferred payment amount of $500,000, outlining payment terms and conditions.
Personal Guarantee: The buyer personally guarantees the payments, adding security for the seller.
Collateral: The business assets or other agreed-upon assets can be used as collateral until full payment is made.

Benefits:

Seller: Assures that payments will be made as agreed.
Buyer: Demonstrates commitment and credibility.

6. Performance Covenants

Management Roles:
The seller remains involved in an advisory role for the first 2 years to ensure a smooth transition.
Operational Decisions:
Major decisions require mutual consent during the transition period, protecting both parties' interests.
Financial Reporting:
Regular and transparent financial reporting to monitor performance and calculate earn-out payments accurately.

Benefits:

Seller: Ensures business is managed properly during the transition, protecting their financial interests.
Buyer: Gains from seller's experience and maintains business stability.

Illustrative Payment Schedule

Closing

$125,000 (Down Payment)

N/A

Total Payment $125,000

Ownership 40%

Year 1

Fixed Payment $100,000