The Hierarchy of Capital in a Seller's Deal

The hierarchy of capital is the order in which a seller should value the different ways a buyer pays for a business: cash at closing first, then rollover equity, then a carry back note, then an earnout. Two offers can carry the same headline price and leave the owner with different outcomes. The terms decide how much of that price the owner controls, when it arrives, and what has to go right for the rest of it to show up.

The Price Is Only Half the Offer

Owners tend to hear the multiple first. Six times earnings sounds better than four, and it is. A letter of intent at six times with half the value tied to future performance can still be worth less to the owner than a clean offer at five.

Most buyers in the lower middle market have closed many acquisitions. For most owners, the sale of the company is the first they have ever made, and often the most important financial decision since choosing a spouse. That imbalance shows up most in the terms, because the terms are where a buyer shifts risk back to the seller.

So the useful question about any offer goes beyond "how much?" to "how much, in what form, and under what conditions?"

Cash at Closing

Cash sits at the top of the list because it is in the owner's hands the day the deal closes. Even when part of it is held in escrow for a period after closing, that money comes to the seller as long as the representations and warranties in the purchase agreement hold up.

Cash also ends the owner's exposure to what happens next. Once it is paid, the new owner's decisions about pricing, hiring, or expansion no longer change what the seller receives. For an owner who wants to move on to the next phase of life, that certainty is worth a great deal. Some owners will accept a lower multiple to get more of the price in cash, and for them it is the right trade.

Rollover Equity

Rollover equity means keeping part of the ownership. Instead of taking the full price in cash, the seller reinvests a portion into the buyer's company, or into the combined company after the deal.

On a $10 million sale, rolling 20 percent leaves the owner with a $2 million interest. If the business is being added to a larger platform, that interest sits inside a bigger enterprise, and the combined company may be worth more than either business on its own.

Rollover is illiquid. The owner cannot spend it until the next sale, and its value depends on whether the buyer turns out to be a good steward of the business. The terms of that equity matter as much as the percentage: whether it rolls into the same security the buyer holds or into a class that sits behind the buyer's preferred equity and its liquidation preference, and whether the rollover can be structured to defer tax. Those are questions for your attorney and CPA before you sign a letter of intent.

An owner who wants to keep working, believes in the buyer, and wants a second payday when the buyer eventually sells may treat cash and rollover as nearly equal. It also helps the buyer, who needs less cash at closing, and that can support a higher overall price.

The Carry Back Note

A carry back note puts the owner in the role of the bank. Instead of the buyer borrowing the full price from a lender, the seller finances a portion, often 10 to 20 percent of the price, and the buyer pays it back over time with interest.

Most notes include events of default, so a missed payment gives the seller some recourse against assets or the stock. Even with that protection, the owner is taking on risk the bank chose to leave alone.

Carry back notes are common in management buyouts, and for good reason. An owner selling to a team they have worked beside for years has a basis for trusting the note. An owner selling to a buyer they met during a sale process has much less to go on.

The Earnout

An earnout pays part of the price later, and only if the business hits agreed targets. One structure we see requires a 20 or 30 percent increase in earnings or gross profit over the year of the sale.

An earnout can pay well, and it is also the least certain form of payment a seller can accept. The owner usually has to stay on and help drive the results, often while a new owner makes decisions that affect whether the targets are met. The seller carries the outcome without controlling the business that produces it.

How Owner Dependence Moves a Deal Down the List

Where an offer lands in this hierarchy is rarely random. It tracks how much the business depends on the owner.

Consider a situation we saw recently. The 70-year-old founder of a distribution business wanted six times trailing twelve months cash flow. There was no management team underneath him and no audit. More than 60 percent of revenue came from two customers, with no contracts. The buyer offered four.

The gap between those numbers is the buyer's view of risk. Those two customers had been loyal for years, and the relationships ran through the founder. If he left, would they stay? Facing that question, a buyer is likely to pay about four times at closing, and put the remaining value in rollover equity and an earnout that depend on the relationships surviving the transition. With revenue that concentrated, a note may be the wrong tool entirely.

A handshake customer who comes back year after year is one of the best things an owner has while running the business. At the sale, that same relationship becomes a question the buyer has to price.

When a buyer requires the seller to stay on as an employee, the buyer is asking the owner to prove the earnings are sustainable before paying for them in full. Terms weighted toward future performance are a tell that the buyer is paying for the owner's continued presence.

Our Transferable Value Index measures this dependence directly. A lower score points to higher integration risk for a buyer, and higher integration risk tends to mean less favorable terms. The logic runs in reverse, too. A business with a strong score gives the owner room to ask for more of the price in cash. The first issue of the Index looked at how owners let go of their businesses in a predictable order, which is a useful companion to this question.

What Lets an Owner Defend a Premium

Two things let an owner defend a premium and better terms.

The first is the integrity of the numbers. Can the owner show real cash flow over a three-year look back, and projections that were set and then met? Many owners have kept their books to whatever standard their bank required: audited, reviewed, or a compilation that no one outside the company examined. A buyer's quality of earnings team will look under the hood regardless, so the time to find problems is before they do. Our guide to the financial ratios buyers review before a sale is a good starting point.

The second is the story behind the revenue. Buyers want to know whether it is contracted or repeat business, and whether new clients are still arriving alongside the existing ones. An owner who can show sustainable, growing revenue gives a buyer a reason to pay for the future.

During a sale the buyer keeps asking for updated trailing financials, and in diligence they take the business for a full test drive. If what they find does not match what the owner presented, the result can be a retrade of the letter of intent, a change in value or terms, or a deal that never closes. We cover the pressure points in more detail in the negotiation challenges owners face.

Why Company Size Makes This Harder

Companies with a few million to roughly ten million of EBITDA sit in an awkward spot. They are often too complex for a basic listing and not yet large enough to hold the attention of the large investment banks. We describe the full ladder in Three Rungs: Broker, Advisor, Investment Bank. Owners in that range are underserved at the moment it matters most, and a thin process tends to shrink the buyer pool, which weakens the owner's position on terms.

Industry matters too. Some sectors are seeing heavy acquisition activity, and demand there can push multiples well above the usual range. The owner cannot control that. The owner can control how prepared the business is when buyers look.

When to Start

We are often asked when an owner should call an advisor. The best time is when you start thinking about what comes next, well before you are ready to sell. That runway, often several years, is what lets an owner raise a weak score, clean up the numbers, and build a team that keeps the key relationships in place. The aim, when the time comes, is more of the price in cash and fewer conditions on the rest. That is where our M&A advisory work begins.

We talked through these ideas on an episode of our podcast, What Transfers.