Performance-Based Promissory Notes (PBPNs)

In mergers and acquisitions (M&A), performance-based promissory notes ("PBPN") are financial instruments that tie the final purchase price to the future performance of the acquired business. This structure allows for a more flexible and risk-shared approach to deal-making.  

What The Heck Is A Performance-Based Promissory Note?

To begin, a seller / promissory note is when the seller of business finances the sale of their business, thereby becoming the buyer's lender. Put differently, instead of the buyer receiving the full acquisition consideration up-front, they will opt to defer to a later point in time. 

The "performance" piece of the PBPN reduces the risk away from the buyer in case the business performs worse than expected, while increasing the risk (and thus potential upside) of the seller. 

Feel free to review this video we created with an example of how a PBPN can be used in an acquisition.

Key Characteristics of Performance-Based Promissory Notes:

• Deferred Payment: A portion of the purchase price is deferred and paid out over time, often in installments.  
• Performance Metrics: The amount of the deferred payment is tied to specific performance metrics, such as revenue growth, profitability, or customer retention, that are evaluated during a "lookback period" that frequently occurs one year after the sale of the business.
• Shared Risk and Reward: Both the buyer and seller share in the upside and downside of the business's future performance. It also creates a strong incentive structure for the owner during the transitioning / consulting period.
• Alignment of Interests: The performance-based structure aligns the incentives of both parties, encouraging the seller to continue contributing to the business's success post-acquisition.  

Common Scenarios for Using Performance-Based Promissory Notes:

• Uncertainty in Future Performance: When the future performance of the target business is uncertain (i.e. you have low confidence in EBITDA projections or have identified headwinds for the business), a performance-based note can help bridge the valuation gap between the buyer and seller. 
  
• Seller Financing: The seller may use a performance-based note to finance a portion of the purchase price, especially if traditional financing is limited.  
• Incentivizing A Sucessful Transition: Performance-based notes can be used to incentivize owners to seek the company's best interests during the phase where they are transitioning out of the business. 

Advantages of Performance-Based Promissory Notes:

• Flexible Deal Structuring: Allows for creative deal structures that can accommodate various deal dynamics.
• Risk Mitigation: For the buyer, it reduces upfront cash outlay and shifts some of the risk to the seller.
• Enhanced Valuation: For the seller, it can potentially increase the overall valuation of the business.
• Improved Post-Acquisition Integration: Aligns the interests of both parties and encourages cooperation.
  

Potential Drawbacks of Performance-Based Promissory Notes:

• Complexity: Structuring and negotiating performance-based notes can be complex and time-consuming.
• Contingent Liability: The buyer may face potential liability if the performance metrics are not met.
• Potential for Disputes: Disagreements over the interpretation of performance metrics can lead to disputes (it's best to simplify performance metrics so that they are clear and easily understandable by every party involved).
  

Why Use An Earn-Out vs. Performance-based Promissory Note?

While both earn-outs and performance-based promissory notes (PBPNs) are financial tools used to bridge valuation gaps and align incentives in M&A deals, they have distinct characteristics:

• Earn-out:
  • Contingent Payment: A portion of the purchase price is deferred and paid out later, contingent on the achievement of specific performance metrics.   
  • No Debt Instrument: It's not a debt instrument; the seller doesn't lend money to the buyer.
  • Performance-Based Payment: The payment is directly tied to the business's performance.
  • Shared Risk and Reward: Both parties share the risk and reward of the business's future performance.
• Performance-Based Promissory Note (PBPN):
  • Debt Instrument: The seller lends money to the buyer in the form of a promissory note.   
  • Fixed Payment Schedule: The note typically has a fixed payment schedule, regardless of performance.
  • Interest Rate Tied to Performance: The interest rate on the note can vary based on the achievement of specific performance metrics.
  • Debt-Based Relationship: It creates a creditor-debtor relationship between the seller and the buyer.
• In summary:
  • Earn-outs are more flexible and allow for a greater degree of risk-sharing.
  • PBPNs provide a more structured and predictable payment schedule, but with a performance-based interest rate.

The choice between an earn-out and a PBPN depends on various factors, including the specific deal terms, the risk tolerance of both parties, and the desired level of alignment between their interests. See below for a table compariang the attributes of Performance-Based Promissory Notes relative to other financing options common in M&A:

Conclusion

Performance-based promissory notes (PBPNs) offer a versatile financial tool for structuring M&A deals. By aligning the interests of buyers and sellers through performance-based payments or interest rates, PBPNs can mitigate risk, incentivize post-acquisition performance, and facilitate complex transactions. However, careful consideration is necessary to ensure the success of PBPNs. Key factors to consider include:

• Clear Performance Metrics: Defining and measuring performance metrics accurately is crucial to avoid disputes and ensure fair outcomes.
• Legal Structuring: Compliance with relevant securities laws and regulations is essential to mitigate legal risks.
• Risk Assessment: Both parties should carefully assess the risks and rewards associated with the PBPN.
• Negotiation: Effective negotiation is key to achieving a mutually beneficial agreement on performance metrics, payment terms, and interest rates.

By addressing these considerations, PBPNs can be effectively utilized to create value and drive long-term success in M&A deals.