11 Feb The Sell Side Masterclass for Tech Services Founders: Deal Structures 101
EPISODE 244.
In this installment of the Sell Side Master Class, Ryan and Mike break down deal structure, the terms behind the headline enterprise value and why structure can matter as much as (or more than) price. They walk through the most common components of consideration in IT services M&A: cash at close, earnouts, seller notes, and rollover equity, including where each can create upside and where hidden risk lives. Mike explains why earnouts often get an unfair reputation, what “good” earnout design looks like, and why indexing to revenue is typically safer than profit. They also cover how seller notes work (and why they’re subordinated to bank debt), what rollover equity really means in a PE-backed deal, and the “often missed” lever of working capital, including how sellers can accidentally leave money on the table without the right guidance. Tune in as we talk Deal Structures 101.
DEAL STRUCTURES WE DISCUSS:
Cash at close: The portion of the purchase price you receive when the deal closes. In the episode, this is framed as the most straightforward form of consideration and the “baseline” sellers compare other components against.
Earnout: A contingent payment you can earn after closing if the business hits agreed performance targets. Mike explains that earnouts often work best when they’re indexed higher on the P&L (commonly revenue, sometimes gross margin) and structured with a “lane” or prorated payout range instead of an all-or-nothing cliff. Example from the episode’s concept: if revenue lands within a defined band around the forecast, you receive a proportional earnout payout.
Seller note: Seller financing where the seller effectively becomes a lender to the buyer for part of the purchase price. The transcript describes this as the seller “acting like the bank,” typically with interest, and notes that it is usually subordinated to senior bank debt. Example conceptually: you receive part of the price over time as principal plus interest rather than all at close.
Rollover equity: The seller reinvests a portion of proceeds into the new ownership structure, keeping equity in the business post-transaction. In the episode, this is discussed as the “second bite of the apple,” often seen in PE-backed deals where the seller participates in future upside at a later liquidity event.
Working capital adjustment: A structural mechanism that sets a working capital “target” at close and adjusts the seller’s proceeds up or down depending on whether the company delivers more or less working capital than agreed. The transcript emphasizes this as an often-overlooked lever and discusses that many owners are overcapitalized, meaning working capital can meaningfully impact what the seller takes home if negotiated correctly.
Mixing structures to optimize EV and share risk: The episode repeatedly frames structure as a way to balance risk between buyer and seller and sometimes increase headline enterprise value. Example concept: a buyer may offer a higher total value if some portion is contingent (earnout) or deferred (seller note) versus paying the entire amount in cash at close.
OTHER EPISODES IN THIS SERIES:
Part 1. Knowing When It’s Time to Sell: Listen now >>
Part 2. Get Your House in Order: Listen now >>
Part 3. Valuation Drivers: Listen now >>
Part 4. What is my Take Home? Listen now >>
Part 5. It Takes a Village. Listen now >>
Part 6. The First 30 Days of a Process. Listen now >>
Part 7. Finding the Right Buyer. Listen now >>
Listen to Shoot the Moon on Apple Podcasts or Spotify.
Buy, sell, or grow your tech-enabled services firm with Revenue Rocket.
EPISODE TRANSCRIPT:
Mike: Hello. And welcome to this week’s. Shoot the moon podcast broadcasting live and direct from Revenue rocket world headquarters in bloomington, Minnesota with me. Today is my partner Ryan Barnett, Ryan. Welcome.
Ryan: How are you today? Hey, Mike. Yeah, hey, thanks for having me, Mike. You know, we’ve been digging in and been doing an old master class series for it. – really focused on it service executives where Revenue Rocket focuses all of our, and so far we’ve really gotten to a point of, you know, getting you into the mindset of how to sell, getting your house in order, understanding what your firm is worth, understanding what you’re going to take home if you do sell your company, building the right team, and then getting really into that process of what it looks like from kind of your month, one of your T’s your CIM and financial, getting that out there finding. And eventually last week, we talked about getting to an Loi stage. And when you get to an LOI, it’s an exciting time. Your buyer and your seller are aligned. And as the seller, you get to really understand, you know, the rubber hits the road. This is where I’m seeing what my firm is worth. And I’m starting to understand what the next chapter of life could look like. And when you typically look at a deal, it starts –, the big number that you look at is what we’d call enterprise value and that’s really the value of your firm and that you’re going to check if it’s going to be struck, that’s what that check is going to kind of look like. In general, however, there’s a thing called deal structure and I want to spend the time here, Mike, today talking about deal structure. So why don’t you just help me understand just the big picture, what is deal structure? And why does that structure matter more than price at all?
Mike: Yeah, good question. Ryan. So, you know, deal structure really is the terms of the deal, not the price of the deal. So price oftentimes or enterprise value, you have a number, right? And that consists of all of the different components that make up consideration to purchase your firm. And in the case of structure is all those components, right? You know, certainly it could be cash which has no structure, all paid of value up front… or it could be all structured, meaning it sort of pays you.
Mike: Over time and it pays you if and when certain things happen, right? You could have all cash at close or you could have some cash at close, some seller note, some earn out, maybe some equity. So, the structure is actually the terms of how you’re going to be paid. And so, you know, I think it is, it’s as important as the enterprise value number because the number at the top is meaningless unless you know what you actually will take home. And structure is what defines what you will actually take home at the end of the day.
Ryan: That’s right. And we talked about this in a prior episode as well, just understanding, you know, what you’re going to take home after the deal. And you might see a headline number. And let’s say that number is 20 million, but not all of that might come at close. There might be conditions. There might be certain things. And so I think, you know, as we unpack this, I just want to make sure everyone understands that, you know, this isn’t necessarily bad. It’s just, it’s, it’s a structure to the deal. And that’s kind of how deals are done.
Mike: Yeah. Most deals have deal structure. Deal structure is not a bad thing because it’ll help you optimize your enterprise value and share risk with the buyer, right? So, if you have all cash at close, the buyer takes all the risk. If you have all structure, you take all the risk. If you have some mix, then it’s a shared risk model.
Ryan: Great. So let’s talk about, you know, the first one that I think that most folks are familiar with and probably hear the most about, which is earnouts. And earnouts seem to get a bad rap. You know, you hear people talk about them and sellers often feel like, okay, it’s maybe like this trick and I’m not going to get paid or, you know, it’s never going to happen. So, just help us understand, what is an earnout? Why do they exist? And are they always bad?
Mike: Yeah. So earnouts are essentially contingent consideration, right? So, you get paid if certain things happen. Earn outs are used by buyers for a variety of reasons. One, it shares risk. Two, it can align incentives. Three, it can bridge a valuation gap. So, if the seller thinks they’re worth more than the buyer is willing to pay at close, you can bridge that by saying, okay, well if you hit these numbers, then you’ll get that additional value. And earn outs get paid out at quite a high percentage of the time if they’re structured properly. Probably over 80 percent of the time if they’re structured properly.
Ryan: That’s interesting.
Mike: They get a bad rap because some buyers will structure them in a way that makes it very difficult to hit, right? Or they’ll structure them around a metric that the seller doesn’t control anymore, right? The best earnouts are indexed high on the P&L. So revenue is a common one. Sometimes gross margin. You typically want to avoid indexing to profit or EBITDA because the buyer controls expenses after the close. And one of the biggest mistakes sellers can make is to index an earn out on profit because you don’t control the levers anymore.
Ryan: That makes a ton of sense.
Mike: Another thing that makes a good earnout is the way it’s structured. You typically want to have a lane, right? So if you say the forecast is a hundred and as long as you keep the forecast in the lane, you get paid a prorated amount. If you do a cliff, like you must hit 100 or you get zero, that can be a problem. So, you want lanes and you want pro rata payouts. And you want to keep earnouts relatively short, one to three years. Three years is common. Longer than that is just too much uncertainty.
Ryan: Yeah. And I think, you know, for a lot of sellers, you also need to understand if you’re selling in or you’re selling out. And if you’re selling in, meaning you’re staying, maybe an earnout makes more sense. If you’re selling out, you’re leaving, it might be a little bit harder. But that doesn’t mean an earnout can’t work if you have the right team and the business is built in a way where it can still hit those targets.
Mike: Exactly. Earnouts work best when the seller is staying involved, but they can also work if the seller is not staying involved if the metrics are designed properly and the team is strong. Or sometimes if the risk is around customer concentration, an earnout can be a way to protect the buyer from a customer leaving.
Ryan: So, in terms of typical size, how big are earnouts usually? Like, what should someone expect?
Mike: It varies, but a typical earnout might be 10 to 30 percent of the total consideration. If there is rollover equity in the deal, the earnout might be smaller because the seller is already participating in upside via equity.
Ryan: Got it.
Mike: And the other thing is, earnouts aren’t inherently negative. They can help you get to a higher enterprise value. They can help align incentives. It’s just critical that it’s structured properly and that you’re indexing to metrics that you can actually influence.
Ryan: Great. So let’s move to seller notes. You hear about seller notes sometimes, and I think in some cases sellers aren’t sure why they exist or what the tradeoffs are. So just break it down. What is a seller note?
Mike: Seller notes are really just seller financing. You’re like acting like the bank to the buyer for a portion of the purchase price. So instead of the buyer paying you all of the purchase price at close, they pay you some at close and some over time with interest.
Ryan: And why would a buyer want that?
Mike: Usually because they want to optimize leverage. They may have senior bank debt in the deal. The seller note can help the buyer close the gap between the equity they have and the total price. Seller notes are typically subordinated to senior debt, which means the bank gets paid first. And the seller note usually carries interest, sometimes mid-single digits up to 10 percent depending on the market and risk.
Ryan: And if something goes wrong, what happens?
Mike: It depends on the note terms, but generally you have a promissory note. There are default provisions. But because it’s subordinated to senior debt, your remedies are limited compared to a bank.
Ryan: Okay. That makes sense.
Mike: Seller notes can be fine. They’re another mechanism of structure. They can help you get a higher overall value, but you are taking on credit risk of the buyer.
Ryan: Great. Now let’s talk about rollover equity, because I know in private equity deals, rollover equity is pretty common. What is rollover equity and why would a seller do it?
Mike: Rollover equity is when the seller reinvests a portion of their proceeds into the new company. So you sell your company, you take some cash off the table, but you keep some equity in the business going forward. It’s often referred to as the second bite of the apple.
Ryan: Right.
Mike: In private equity-backed transactions, rollover equity is extremely common. The thesis is, private equity is buying a platform and they want the management team aligned. So you roll equity, and then at the next liquidity event, you get another opportunity to cash out, often at a higher valuation if the growth plan is executed.
Ryan: So it can be upside.
Mike: Exactly. It can be upside. It also means you have risk, because equity can go up or down, and it is subject to terms, governance, and the timing of a future liquidity event.
Ryan: Great. Now let’s talk about something that I think doesn’t get talked about enough, which is working capital. We hear working capital adjustments, targets, all that. Why does working capital matter in deal structure?
Mike: Working capital is a big lever that a lot of sellers miss. Almost all business owners are overcapitalized. They’ve got excess working capital in the business and the only time you can harvest that excess working capital is when you sell.
Ryan: Yeah.
Mike: Working capital adjustments usually set a target. If you deliver more working capital than target, you may get paid for it. If you deliver less, your purchase price gets adjusted down. And this can materially change what you take home at close. So, you want to negotiate working capital properly. You want to understand what is normal working capital for your business. You want to be careful that the buyer doesn’t set an unreasonable target.
Ryan: Totally.
Mike: And because many sellers are overcapitalized, there can be an opportunity to structure the deal so you can harvest some of that value at close.
Ryan: That’s great. So, as we close this out, just to recap, deal structure isn’t inherently bad. It’s part of how deals are done. It can help optimize enterprise value and share risk, but you need to understand the terms and make sure it’s structured fairly.
Mike: Exactly. Deal structure really is the terms of the deal, not the price of the deal. And the headline enterprise value doesn’t matter unless you understand what you’re actually going to take home. So, it’s important to work with experienced advisors who can help you negotiate these terms because it’s easy to leave money on the table.