The Risks of Post-Sale Payments in Advisory Firms
How deferred payments and conditions in sale agreements impact expected earnings.
1Structure of Advisory Firm Sales
In the sale of advisory firms, buyers often do not pay the total sale price at closing. Instead, a significant portion of the payments occurs years after closing and only if certain conditions are met. These conditions may include client retention rates or specific growth rates. This situation shows that sellers may not receive the valuation multiples they initially expected.
2Time Value of Deferred Payments
Deferred payments in sale agreements carry significant financial risks for sellers. For example, only 50% of a deal may be paid in cash at closing. The remaining payments occur within three to five years. This requires sellers to consider the time value of money. Additionally, changes in the buyer's financial situation can put the payments entirely at risk.
3Client Retention Conditions
Post-sale payments are often tied to client retention conditions. For instance, a certain percentage of clients or revenue must be retained for one to three years after closing. These conditions create additional challenges for sellers as client losses can occur due to taxes, dissatisfaction with the new buyer, or other factors. This situation can develop beyond the seller's control.
4Impact of Market Conditions
Market conditions can significantly impact post-sale payments. For example, market downturns can lead to client losses or revenue declines. While some firms offer market-neutral revenue retention clauses, this can disadvantage sellers during market upswings. Such conditions increase the risk of sellers not receiving expected payments.
5Growth Conditions and Earnouts
Earnouts in sale agreements may require not only client retention but also a specific growth rate. For example, a 20% compound annual growth rate (CAGR) condition may require the seller to grow the business 2.5 times within five years. Such conditions can be highly challenging for sellers as they no longer have full control over the business.
6Buyer's Control and Risks
Post-sale, the buyer may make changes to the investment strategy, pricing, or staff support. This can make it difficult for the seller to achieve growth targets. Additionally, the buyer's right to terminate the seller without cause can further reduce the chances of meeting earnout targets. Therefore, sellers must carefully review the agreement terms.
7Negotiating Agreement Terms
Sellers can negotiate client retention, earnout, and termination conditions with buyers. For example, clauses limiting terminations without cause can be added. Such terms can increase the seller's chances of receiving expected payments. Additionally, comparing different offer letters can provide opportunities for more favorable agreements.
8Conclusion: Realizing Expected Earnings
In the sale of advisory firms, focusing solely on initial valuation multiples is not enough. The amount sellers actually receive is more important than the deal's paper value. Therefore, sellers must carefully review and negotiate agreement terms to maximize expected earnings.