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Financing A Deal
There are several basic methods of financing a business buyout. Most of the basic methods have a myriad of variations available. The methods outlined below are the most common. However they are often used in combination with different kinds of modifications and twists. As with most other transactions in a market based free economy, buyer and seller are free to negotiate any terms and any prices that they wish.
Seller Financing (Taking Paper)
Most sellers would prefer to get 100% cash for their businesses. Most buyers would prefer the opposite: to get nearly 100% of the deal financed by the seller. Most transactions happen somewhere in between those two extremes. The fact is that owner financing or (taking back paper) is the magic that makes many small business sales happen.
Whenever a seller tells me that they will only take an all cash deal I tell them "If you have two buyers and one offers $4,000,000 in cash and the other offers $4,000,000 in cash and a note for $500,000, the one with the note is clearly a better deal." Every deal needs to be evaluated in total.
As a small business owner, you know first hand the difficulties involved in borrowing from a bank. The bank nearly always wants collateral in the form of real estate or something else of tangible value. Seldom is the business alone enough to secure financing. From the banker's point of view this makes sense. If the business owner can't pay a loan, real estate (your house!) can be easily sold. However, business equipment and failing businesses are a different story. From a banker's perspective, a business and its assets have value only as long as they are earning money. The last thing a banker wants to do is come in and take over a small business that he knows nothing about running.
However, you as the business owner do know how to run your business. If the buyer can't pay the loan to you, then you can take the business back and run it. The security in the business (that you will insist upon holding) has real value to you but has only minimal value to the bank. Further, while rates on owner financing vary, a rate of prime or a bit higher is typical. That is, most owner-financed deals are financed at a rate lower than a bank will lend to a small business but higher than it will pay on a CD or savings account.
If you finance the deal under the parameters outlined, you have a secured loan at a rate of interest higher than a bank will pay you for your money. In some instances a buyer will guarantee the note personally, which adds a measure of assurance that you will be paid.
In practice, most business sales include some owner financing, typically 20% to 35% of the total but sometimes much higher. If the security is strong (tangible assets, real property, personal guarantees) then a higher amount of owner financing can justified.
Some sellers decide on a minimum price that they want for the business and consider taking anything over that amount in owner financing. In this way, the most you can lose is the amount received that is over your lowest acceptable price.
Buyers who fall in love with your business are very anxious to make the deal happen. They are inclined to look less at the price and more at ways to make the deal go through. Owner financing then:
- can result in a higher sale price
- can help make the deal happen
- can earn you a favorable interest rate on a secured loan
As a seller you may not want the business back, especially if the buyer has left it in bad shape. You may have taken another job, retired, moved out of state. If you will not be in a position to take the business back you can sell the note. There are many buyers of such notes. They will want a discount, based on the interest rate the note carries and the risk involved.
Leveraged Buyout
A leveraged buyout is simply a buyout financed in part by a bank or another financial institution. The assets of the business are used as collateral for borrowing.
While many if not most small businesses are bought with bank financing, the assets of the many of these businesses are of limited value as collateral. The bank will generally insist that more solid assets (such as real estate) be pledged before they will finance a deal.
Earn Outs
An earn out is an arrangement whereby part of the seller's payment for the business is based on the performance of the business after the deal is closed. For example, let's suppose that a seller is asking $200,000 for his business, which includes $80,000 of inventory at cost and $20,000 of equipment and other tangible assets at fair market value. A buyer may offer $100,000 at closing with an additional payment of 20% of the firm's gross sales over the twelve months following closing.
Rather than gross sales, the benchmark can be net sales or net profits (as long as net profits are clearly defined). The point is that the seller's compensation is tied to performance of the business in some way.
Earn outs are often used when buyer and seller disagree as to the projected performance of the business or if past performance due to poor records make an analysis of past performance difficult.
Earn outs are also typical if there exists the possibility of an extraordinary event that would significantly impact the business's performance, either positively or negatively. For example, suppose a donut shop owner wants to sell his shop, but there is a proposal for a major competitor to open up a block away. This would likely scare off a buyer. However, an earn out structure might make the shop more saleable because the buyer and seller would then essentially be sharing the risk.
Similarly, the owner of a manufacturing firm may want to sell but may be hesitant because a major contract is on the verge of coming through. Under an earn out agreement if it does come through, the seller would receive some of the financial benefit; whereas if it doesn't come through the buyer would not be paying for a contract that didn't materialize.
Consulting and Employment Fees
It is not unusual for a seller to get a payment for the business plus a guaranteed salary or consulting fee for a negotiated period of time. Sometimes a seller will be paid an inflated salary or consulting fee with the understanding that the inflated amount is actually compensation for the business. The effect here is to assure the seller's continual help and cooperation in running the business. A warning here is to talk with your accountant before entering into a clearly inflated compensation agreement. Such an agreement has tax advantages to the buyer but may be challenged by the IRS.
Keep It Simple
It has been my experience that the more complex the deal is; the more likely it is to fall through. Some people, advisors and principals alike, love the challenge of structuring deals with options, separate corporations, graduated earn out provisions, and a host of other elements. Sometimes these complexities are necessary tools to bring a deal to fruition. More often such complexities lead to misunderstandings between buyer and seller that at the least require highly paid advisors to untangle and explain, and at worst lead to someone backing out of the deal because he or she doesn't understand it.
I recently had this happen to me. A buyer proposed a relatively complex deal. The buyer indicated that he didn't understand it. He asked me to explain it to his lawyer and his CPA, which I did. Both his lawyer and CPA told him the deal looked good. He went along with the deal but later indicated that an important element was different than he thought it was. He then decided that he would not go along with any deal that he couldn't understand based on his own reading of it. We were back to square one.
A Partial Sale
Sometimes a seller retains a stake in the company to share in its future growth. This is most common when selling to a VC (Venture Capitalist) or PEG (Private Equity Group). Be careful, because as a minority shareholder in a closely held enterprise it is hard to protect your interests. The new owner can hire his wife and brother at inflated salaries or use other ploys to reduce the profits in which you share. Make sure that you trust the buyer and that you consult with a good attorney before becoming a minority shareholder in any enterprise.
Structures can be very creative. For example in one deal we saw the following structure: A PEG acquired 3 companies with related ownership and combined them into one, with the goal of growing the new company and taking it public in 5 to 7 years. The PEG got 40% ownership in the new company and the existing owners retained 60%. To assure themselves a decent return, the PEG's shares were preferred and had a 10% cumulative dividend, which was never paid. If at the time the PEG exited the transaction their return met or exceeded 10% the dividend was forgiven, otherwise it was payable at the time of the transaction, before the proceeds were distributed to the other owners. Finally, to ensure that the owners did not take advantage of a minority partner any owner could force a sale with 90 days notice (a mighty big stick).
Another partial share scenario that may be of interest is if you are approaching retirement age and don't really want to stop working. You can put your company on the market now, and if the right buyer comes along offer to sell 40% today with an agreement that your partner will buy the remaining portion of the business after some number of years, based on a predetermined formula. It allows you to diversify your investments now, keep working, share in the growth of your company, and have an exit strategy worked out. From the buyer's perspective, there is less up front risk, more time for the buyer to learn the the business, and less worry that you are selling now because you believe that the business is in serious jeopardy.
Summary
Buyer and seller are free to construct a deal in virtually any way they wish. While the basic methods are described above, any combination or any other methods that buyer and seller come up with are fair game. It is not unusual for a creative financing structure to resurrect a dead deal or to make an unattractive business much more attractive. However, you are advised to keep the deal from getting any more complex than is necessary. The more complex the deal, the more likely it is to fall through.
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