The Importance of Deal Terms in Business Sales
As a business owner, you’ve spent years building your company, overcoming challenges, and creating a profitable operation. Now, whether you’re facing retirement, experiencing burnout, or dealing with personal matters, you’re ready to consider a sale, making it essential to evaluate the deal terms carefully.
With a company in the $2 million to $20 million revenue range, the common focus might be on obtaining a high valuation—but valuation alone doesn’t guarantee a favorable outcome. The terms of the deal within the sale agreement can be even more impactful, shaping what you ultimately receive, your risks, and your financial and legal security post-sale.
For software, media, or service-based company owners, understanding deal terms like liabilities, deferred compensation, and earnouts is crucial for maximizing the transaction’s value while minimizing risks to your customers and your business. Here’s why deal terms often matter more than the valuation.
1. Beyond Valuation: Why Payment Terms Are Critical to Your Sale
Securing a high valuation is a strong starting point, but the payout structure—how and when you receive it—makes all the difference. For example, an “all-cash at closing” deal offers immediate financial security but can reduce the buyer pool, while alternatives like seller financing or earnouts carry added risk. Here’s a breakdown of common payment structures:
- All-Cash Payment: This is typically the most desirable structure for sellers, offering a set amount of immediate liquidity and reducing future risk. While an all-cash deal might yield a slightly lower total purchase price, it eliminates the chance of missed payment issues down the road.
- Seller Financing: In this arrangement, you agree to finance part of the sale price, effectively acting as a lender to the buyer. This expands the number of potential buyers. Securing these payments with collateral or personal guarantees is essential to mitigate potential losses. Should the buyer miss a payment, you made need to take legal action to collect what’s owed.
- Earnouts: Earnouts tie part of your compensation to the business’s performance after the sale. While earnouts can theoretically raise the final payout, they’re often fraught with risk. As the previous owner, you won’t have control over business decisions, making it harder to ensure that performance targets will be met. For many sellers, earnouts create more risk than reward, especially if tied to factors like revenue growth or profit margins, which may be outside your control.
Pro Tip: Ensure the terms are as specific as possible when considering earnouts, leaving little room for ambiguity or other variables. Define clear, achievable targets that aren’t prone to manipulation and gamesmanship.
2. Deferred Compensation: Risks and Realities
Deferred compensation agreements can attract buyers by spreading the payment over time, reducing the initial cash outlay. However, these arrangements carry risks for sellers, mainly if they’re not structured carefully.
Deferred payments depend on the buyer’s continued financial health, ability to generate cash flow, and other variables that can be unpredictable. In some cases, buyers might default on payments, leaving you in a position where recovering the full agreed price is difficult.
To protect yourself, ensure that any deferred payments are secured with collateral or have guarantees. Requiring the buyer to provide regular financial statements and personal guarantees on deferred payments helps mitigate these risks.
3. Indemnification Clauses and Liability Limitations: Protecting Your Interests
Indemnification clauses define which party is responsible for specific liabilities post-sale. Without clear, favorable terms, you could be held accountable for unforeseen issues long after you’ve handed over control of the company. Indemnification can cover various issues, from outstanding lawsuits and tax obligations to environmental liabilities or contract disputes.
- Cap on Liability: Negotiate a cap to limit the dollar amount you could be liable for post-sale. Typically, this is a percentage of the purchase price.
- Survival Period: Set a reasonable survival period for indemnification claims—often one to three years—to ensure you’re not indefinitely exposed.
- Specificity in Terms: Ensure each indemnification term is detailed to avoid ambiguous language that could be interpreted against you in the event of a dispute.
Having well-defined indemnity and liability clauses as part of your deal terms is essential.. They ensure that you’re not unknowingly taking risks that could impact your finances and peace of mind after the sale.
4. Earnouts: Why Tying Payouts to Future Performance Can Be Risky
Earnouts are a double-edged sword. While they can potentially increase your overall payout if the business thrives post-sale, they also leave you exposed to numerous risks:
- Loss of Control: You no longer have decision-making power once the business changes hands. This is a significant risk if the payout depends on the company hitting financial benchmarks.
- Buyer Mismanagement: If the buyer’s management style leads to revenue declines or increased expenses, you may miss out on part or all of your earnouts.
- Potential for Litigation: Disputes over earnout metrics are common. Clear, specific, and easily measurable earnout metrics can reduce the chance of conflict, but earnouts are still among the most litigated deal terms.
If you’re considering an earnout, ensure it’s tied to specific, measurable outcomes, not subjective goals. For instance, rather than relying on profit targets, tie the earnout to revenue, customer name retention, or other easily quantifiable figures.
5. Deferred Compensation and Seller Financing: Securing Payments and Reducing Default Risk
Seller financing and deferred compensation are both ways to increase your pool of potential buyers, but both bring unique risks.
- Securing Payments: To protect against defaults, request that any deferred compensation be backed by collateral, such as business assets. Alternatively, ask the buyer to sign a personal guarantee. This gives you recourse to claim unpaid amounts if they default.
- Regular Financial Reporting: Require periodic financial reports from the buyer to ensure they meet the financial benchmarks to cover their obligations.
- Personal Guarantees: Personal guarantees can provide critical financial security when the business itself is the only asset being sold. They ensure that you can personally pursue compensation from the buyer in the event of default.
These measures can help protect against unexpected losses and are crucial if your deal includes seller financing or deferred payments.
6. Working Capital and Inventory Adjustments: A Critical Aspect of Pricing
Working capital adjustments ensure that the business maintains its operational cash flow post-sale. Buyers typically require the business to have a certain level of working capital at closing, often adjusted at the last minute. If you disagree with a straightforward method for calculating and adjusting working capital, it can result in lower net proceeds.
- Standardized Method: Agree on a standardized working capital calculation early in negotiations to avoid disputes.
- Inventory Considerations: For service-based companies with inventory or software businesses with prepaid contracts, ensure the accounting method for these assets is consistent to prevent misunderstandings.
7. Non-Compete and Non-Solicitation Agreements: Securing the Buyer’s Investment
Non-compete and non-solicitation agreements protect the buyer’s interest, ensuring you won’t open a competing business immediately or solicit former employees and clients. These terms, however, can limit your future options. Ensure that:
- The Scope is Fair and Limited: Non-compete agreements should be reasonable in both geographic scope and time. For software or digital media businesses, limiting the scope to a few years and relevant industry areas can make the deal more appealing to the buyer without severely limiting your post-sale opportunities. Some states have very specific laws on acceptable non-compete agreements and terms. Consult with your attorney about each state where you have employees.
- Non-Solicitation Agreements are Practical: Ensure the non-solicitation terms won’t hinder your ability to maintain your professional network after the sale.
Prioritizing Deal Terms for a Successful Business Sale
Selling a business you’ve spent years building can be one of the most rewarding decisions of your career—if handled right. The deal terms you negotiate can significantly impact your outcome, from securing immediate liquidity to minimizing future risks.
For business owners facing retirement, burnout, or personal reasons, taking the time to understand and negotiate favorable terms will set you up for a smoother exit and protect the legacy you’ve built.
While achieving a strong valuation is important, the deal terms—payment structure, liability, indemnifications, and protections—often carry more weight in determining how beneficial the sale truly is for you. Prioritize these terms to maximize the outcome and secure the most favorable exit possible.
