Should you go for a VTB or an earnout when selling or buying a construction business?
With the competitive nature of the construction industry and relatively low barriers to entry, there are always several new businesses cropping up in the industry and several mergers and acquisitions taking place. After all, mergers and acquisitions are one of the top ways for construction businesses to grow and expand. However, many problems can arise when it comes to structuring a business sale. One of these problems is the seller and the buyer being unable to settle on the value of the business being sold.
For a seller of a construction business, it would be ideal if the buyer went forward with the sale and paid the full market value of the business in cash. Of course, that is an ideal situation and one that does not always – if ever – occur.
In reality, a seller might focus on the recent growth of the business and hope to make a sizeable profit from the sale. On the other hand, the buyer is likely thinking about the business's past earnings and the possible risks associated with operations post-sale that might affect future earnings. As such, the sellers and buyers of a construction business would have trouble settling on a sale price.
When the sellers and buyers cannot settle on a value for the business, they may seek out alternative, innovative financing solutions. Two of these solutions are earnouts and vendor takebacks. Read ahead to find out what earnouts and vendor takebacks are and the benefits and risks of both options.
What Is an Earnout in the Sale of a Construction Business?
An earnout is a financial solution to buying a business whereby the buyer pays a portion of the purchase price for the business upfront, and the remaining portion is paid after the sale is closed. The portion that remains to be paid depends - either in part or entirely - upon the whether or not the business achieves its financial goals and is paid as a percentage of the business’s earnings or gross sales.
Earnouts are quite common in acquisitions, especially in the construction industry, where a business's future cash flows are uncertain, and there is the possibility of high growth. While the earnout, in many cases can usually be set at about one-third of the total sale value of a business, the actual structure of the earnout is decided based on the due diligence report.
A seller may agree to an earnout if they think the construction business is experiencing sustained growth and will continue to do so. Therefore, they are willing to risk the amount they receive from the earnout. This, in turn, gives the buyer more confidence in how well the business might do in the future and is an added incentive to buy the business.
The Benefits of an Earnout
● A big advantage for a buyer is that they do not have to pay for the business entirely upfront and can pay a portion of the selling price over a longer period of time.
● Another advantage for a buyer is that if the business does not perform as well as predicted, they end up paying less than expected.
● An advantage of an earnout for a seller is that they can spread the taxes on the sale out for the duration period of the earnout, thereby reducing the overall amount of tax they pay for the sale.
● Another advantage for the seller is that they can continue to get more compensation if the business keeps reaching or exceeding its financial goals, meaning there is no limit to how much profit the seller can make.
The Risks of an Earnout
● With an earnout, the seller of a business might end up being involved with the business for a long time, even after the sale. This can be a disadvantage for the buyer if the seller tries to intervene in how the business is being run to increase earnings.
● A significant risk of an earnout for the seller is that they may not make as much profit as expected from the sale of the business if the business does not meet the set financial goals. In other words, the seller does not have a guarantee of future payments should the business not do well.
What You Need to Know About Earnout Negotiation
One of the most important decision factors of an earnout for a construction business sale is negotiating which metric the future payments will be paid based on. There are usually three metrics that are considered: revenue, EBITDA, and gross profit. If the seller and buyer wish to use an earnout as the method of moving forward to the sale, then they both must agree on which of these three metrics is chosen.
Revenue is usually a metric preferred by the seller. Revenue is easy to calculate, and if the seller stays on after the transition period, then they can control business operations and influence total revenue earned. EBITDA is the more common metric used for earnouts and is preferred by most buyers since it closely represents the business's actual cash flows.
Ultimately, gross profit is the metric that sellers and buyers tend to compromise on, given that it is a metric that cannot easily be manipulated. It equally represents the interests of both the sellers and the buyers.
What is a Vendor Take Back in the Sale of a Construction Business?
When a buyer wants to buy a business on sale but does not have the money to purchase it, there are a few options to consider. The vendor could try to take out a small business loan to make the purchase, or they could consider a vendor takeback – also known as vendor financing or seller financing. In a vendor takeback, the vendor – or the seller – helps the buyer finance the sale over a specific period. The amount the buyer then owes the seller is decided and capped, with a repayment schedule mapped out.
Construction businesses are the perfect example of businesses suited to a vendor takeback financing solution. This is because construction businesses can make steady sales over time and usually make operating profits. So, if the seller of a construction business offers buyers the option of a vendor takeback, they can increase their pool of buyers to choose from and guarantee steady future payments.
In typical vendor takebacks, the buyer pays a certain portion of the total selling price upfront and pays the rest over a decided-upon period of time. In such a case, the seller might finance up to two-thirds of the sale price, which the buyer will pay back within two to five years.
The Benefits of a Vendor Take Back
● Vendor takeback financing is often easier for the buyer since the remaining value of the sale price is paid to the seller over a period of time and on a pre-decided schedule. This term is usually shorter than the term for a bank loan, with a typically lower interest rate as well.
● The buyer can usually use the business’s cash flows to start repaying the seller the remaining amount of the purchase price.
● Another benefit of a vendor takeback is that this method of financing a sale usually ensures that the seller stays engaged with the business even after the sale is completed, which can help make the transition period much smoother.
● A specific benefit for the seller is that a business can be sold for up to 15% high selling price when vendor takeback financing is offered. The seller can also earn an added 5 to 15% of the sale price in interest over a five-year repayment term.
The Risks of a Vendor Take Back
● A particular risk that the seller needs to be aware of is that the business is not guaranteed to succeed under the new ownership, which can be a problem if the seller has their money tied up in the business’s sale.
● The buyer also has to agree to a previously decided upon repayment schedule but might be unable to make the payments for some unforeseen reason.
● A disadvantage of vendor takeback financing to consider is that this method of financing can increasingly complicate the purchase and result in higher legal fees having to be paid. This fee falls upon the buyer in most cases.
● Additionally, the new buyer may not necessarily want the seller involved in the business after the transition period and might not appreciate having to accommodate the seller.
Including the Proposed Vendor Takeback Financing in the Sale Offer
If you are considering buying a construction business where the seller is offering a vendor takeback financing option, it may be in your best interest to include a proposed vendor takeback in your offer. You should include how long you would like the repayment term period to be and a proposed interest rate to work off of.
This time period should be shorter than the term for a bank loan, and the interest rate should also be slightly lower than that of a bank loan. It is important to be completely transparent in your proposed offer so that the seller can see this as a sign of goodwill and consider selling the business to you.
The Bottom Line: Should You Go for an Earnout or a Vendor Takeback?
Mergers and acquisitions are the easiest way for construction businesses to grow in a highly competitive industry. When it comes to deciding upon the value of a business and settling on a selling price, however, sellers and buyers can tend to disagree. For this reason, earnouts and vendor takebacks are both great financial solutions.
When selling or buying a business, it is important to think about which of these two financial solutions is best suited for you. Both earnouts and vendor takebacks have their own sets of benefits and risks for sellers and buyers alike. At the end of the day, when trying to sell or buy a construction business, it would be a good idea to get in touch with a professional team of business advisors to help you make the right decisions.
N3 Business Advisors - Construction Industry Mergers & Acquisition Advisors
If you are interested in looking into alternative financing options like earnouts and vendor takebacks for the sale of a construction business, then N3 Business Advisors can help you.
N3 Business Advisors has a team of professional advisors trained to advise construction industry businesses on how to carry out mergers and acquisitions.
Whether you need help with company growth, preparing your business for sale, valuing your already existing construction company, acquiring, merging, or any other goal, we have a qualified and diverse team that is ready to help. With over 30 years of experience in the industry, our team of lawyers, valuation experts, financial and business advisors, and other professionals can help you cover all the bases.
You can get in touch with N3 Business Advisors now to schedule a confidential consultation.
Visit our website for more information, or call us at 647 967 4222. You're just one step away from getting your construction business to where you want it to be! We are based in Ontario, and our office is located at 55 Village Centre Place, Suite 200, Mississauga, ON L4Z 1V9.