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The top-line purchase price for the sale of an RIA often garners the most attention. But this figure can be misleading and does not tell the whole story or reveal whether the deal is favorable for the seller or buyer.
To understand why, it’s vital to explore the other aspects of the deal structure that typically accompany the sale of an RIA including any purchase price adjustments and earnouts included as part of the deal. As the old saying goes, “You tell me the price, and I’ll tell you the terms.” Therefore, it behooves those selling or buying an RIA practice to understand how such concepts work to structure the transaction in a manner that is the most beneficial for them.
In this article, I provide a roadmap for understanding how purchase-price adjustments and earnouts work when it comes to RIA merger transactions. For an article discussing key factors utilized in valuing an RIA in an M&A transaction, click here.
What are price adjustments?
The purchase price announced in a merger or acquisition is not always the amount that the seller receives. This figure can be subject to various adjustments, which can significantly alter the final payout. These adjustments are typically outlined in the purchase agreement.
Downward adjustments can occur for a variety of reasons. The most common occurs when the anticipated post-closing revenues received from clients or earnings of the seller do not live up to buyer expectations based on the pre-closing representations by the seller. The buyer may request a downward purchase price adjustment to reflect a loss of clients, a decline in revenues received from clients, or a decline in earnings from the business acquired after the closing. These downward adjustments can take various forms. Most commonly, the purchase price is adjusted downward based on the shortfall in client count, revenues, or earnings measured over a period of time (such as one or two years after the closing). But such downward adjustments do not always kick in right away, as the buyer and seller may negotiate some leeway to account for minimal attrition following the transaction (e.g., the downward purchase price adjustment does not kick in unless the buyer receives, after the closing, less than 90% of revenues expected to be received based on what the seller earned from such clients during the agreed-upon measurement period before the closing).
In addition to price adjustments based on client retention, future revenues, or future earnings, other purchase-price adjustments can include:
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Working capital adjustments: The purchase price may be adjusted based on the working capital of the business at the time of closing. If the working capital available to the buyer post-closing is lower than a predetermined target, the purchase price can be reduced accordingly.
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Net-asset adjustments: Similar to working capital adjustments, if the net assets of the business are lower than expected at closing, the purchase price may be decreased.
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Indemnification claims: If the buyer incurs losses due to breaches of representations, warranties, or covenants by the seller, the purchase price can be adjusted downward to cover these claims.
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Contingent liabilities: If the business has potential liabilities that are contingent on future events, the purchase price may be adjusted to account for these risks.
These adjustments are designed to assure the buyer it has not overpaid for the business should circumstances arise after the closing that result in unexpected losses. For the seller, it means that the headline purchase price is not guaranteed and can be reduced based on various factors as described above. As such, it’s vital for sellers to understand these adjustments when reviewing any deal proposal.
What are earnouts?
The purchase price may not be the only compensation that a seller receives as part of the sale transaction. Sellers can negotiate earnouts that entitle them to receive additional compensation post-transaction based on milestones agreed upon with the acquirer that typically involve growth in the number of clients or revenues received from clients after the closing of the transaction.
Earnouts can be structured in various ways, such as:
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Fixed payments: The seller receives fixed payments if certain performance targets are met (e.g., the seller receives an additional $1 million over the purchase price if post-closing revenues increase by 15% during the first year after the closing).
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Percentage of revenue or profits: The seller earns a percentage of the business's revenue or profits over a specified period after the closing (e.g., the seller receives 25% of any increase in client revenues for the agreed-upon earnout period).
Therefore, sellers that are not satisfied with the purchase price being offered by an acquirer can request for the deal to include an earnout that allows the seller to receive more compensation if the mutually agreed-upon targets or milestones are achieved by the seller.
Conclusion
While the headline purchase price in an RIA merger transaction may seem like the most important term in the deal, it's essential to look beyond this number. Purchase-price adjustments and earnouts play significant roles in determining the true value of the deal for the seller and buyer. As a result, buyers and sellers should arm themselves with the tools appropriate to negotiate the best deal possible and retain advisors who can navigate these negotiations to best suit their needs. For a step-by-step guide on understanding RIA merger transactions, click here.
Richard Chen is a managing partner with Brightstar Law Group, a law firm that serves investment advisory firms by providing proactive business-minded solutions pertaining to corporate and securities law-related matters. Among other things, our firm provides counsel with respect to securities and compliance matters (including representation in SEC examinations), private fund formation, corporate formation and structuring, business transactions (including M&A and joint ventures), contract drafting and negotiation, employment law matters, operational due diligence, and succession planning. For more information, please visit our website at www.brightstarlawgroup.com or call us at 917-838-7398.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
