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Seller Financing series of articles: Taxes, “Bad Books,” and Bridge Loans

Before you make any decisions on how to structure the sale of your business, educate yourself on the tax consequences, and several tried and true methods of minimizing the amount of taxes you must pay on your sale proceeds.  Take some time to meet with your CPA and your business broker to create a plan for payments by the buyer that optimizes the amount of the sales price you get to keep.

Seller financing can be an important tool in this process.  Instead of getting a lump sum payment for the sale of your business, you can use seller financing as a mechanism to defer taxes until the period when you receive the payments (per IRS publication 537).  This may also have the ancillary effect of putting you in a lower tax bracket than you might be with getting the entire purchase price at one time.  I’m not trying to take the place of professional advice specific to your own finances, just showing you the outline of options available to you in a business sale.

Consider that while you were running your business, you probably made a salary. Then, when you sold your business, you received the net proceeds of the down payment. These two items may push you into the highest tax bracket possible for your earnings. Now, if I’m you, the last thing I want to do is waste 30% to 40% of my money on taxes if there are other options.

You can defer taxes to a later tax period by splitting the proceeds into monthly (or quarterly) payments from the buyer versus a lump sum.  This may keep you from being pushed into the highest possible tax bracket. If you, along with the expert advice of your business broker and CPA, can create the best schedule of payments for you tax-wise, you can pay a lot less in taxes on the overall sales price of your business, this could be a significant savings indeed.

I have seen many sellers choose to amortize the loan over a full 10 years so that they are never pushed into the higher tax bracket. This tax savings depends on your particular situation and tax position. Ask your CPA for more specific information about your particular situation.

Spreading out the timing of payments to minimize tax burden is only one reason to use seller financing.  Another reason is to avoid the stigma of “bad books.”

Candidly, “bad books” is one of the main reasons business owners have no other choice but to offer seller financing. Now, don’t get offended. I am not suggesting that “bad books” are illegal or improper.  What I mean by “bad books” is when sellers minimize their tax burden along the way, for instance, by expensing everything in the world that you can, thereby making your company look less profitable. Did I say that with tact? Was that the “politically correct” explanation?

Now, I’m not saying you did this, but if you did, you know what I mean. You expensed items that a new buyer would not have. That may mean you paid less in taxes, but it also makes your company less profitable (the difference between income and expense), and less valuable, and the end result may be that a bank may not finance the business acquisition.

Another side effect of “bad books” is that a buyer will not pay cash. Why would they? Yes, they may have the money (in fact, when I sold my business, the buyer DID have the cash), but they want to MAKE SURE that the “discretionary” expenses really are discretionary.

Candidly, while I do not recommend keeping your records in this manner, we see this in a good portion of the cases we come across. The buyer may have come out of corporate America, where they received a salary and a benefits package that was clearly reported to the IRS.  Therefore, while the buyer may understand what you did, they may not completely understand if the money will be there for them in quite the same amount.

One way or the other, the buyer wants you to have confidence in the business at the level that you will finance the business. This shows that these “discretionary” expenses really can translate to profit for the buyer.

BRIDGE LOANS:

You could consider offering a bridge loan to the buyer. Many banks will not offer financing for any amount of the purchase over the “liquidated value” of your assets. Why? Because they do not have someone like you on their staff – someone that understands the business the way you understand the business. They have no one that the buyer can call to ask questions. When banks loan businesses money in excess of their assets, they have a relationship with the business and the borrower (both).

However, many banks that will not finance the acquisition of a business WILL offer financing to an established business for the use of consolidating debt. If you do not want to carry the note for a longer period of time to realize the most money for your business, consider offering a bridge loan.

Why is it called that and what, exactly, IS a bridge loan? This type of loan is called a “bridge loan” because it helps the buyer get to the place where a bank will offer financing. You may offer financing for as short as 24 months to as long as 5 years. Typically, a bridge loan is for a period of three years.

Here is how it works: the loan is amortized for 10 years, but with a balloon payment after 3 years. At the point of the balloon payment, the buyer goes to a lender and acquires a loan to pay off the original loan. Once a buyer has had the business track record of three years combined with financials that truly reflect the profitability of the company, it is much easier for them to get the needed loan to pay off the seller.

NOTE BUYERS

Another option that you have as a “bank” is to sell your loan to a note purchaser. While I am not a big fan of this method, it is an option for some. The note purchaser will purchase the loan from you once the loan is “seasoned” – or 3 to 6 months after closing. A note purchaser pays you a discounted amount for your note. For example, if you have a $1,000,000 note at 9% interest, the purchaser (depending on a number of variables) might give you $800,000. You would take a “hit” of $200,000 plus the interest that you have lost (which is the main reason that this is a problem), but it is an option. Furthermore, because you actually got 30% more for your business, you could STILL sell the note and make more money over a 12- to 24-month time frame than if you had received 100% cash at the closing table.

Benefits of Being the Bank for Your Business Sale

Deciding whether your business sale should be a cash sale financed by a bank or seller financed (or even some variation between those) is an important step in the process of preparing for sale. Odds are that if you are planning on selling your business, you picture yourself receiving a very large cashier’s check or wire transfer in exchange for handing over the keys to your business, and then each of you - seller and buyer - then go your separate ways.

In our everyday lives, when we sell something, we typically wash our hands of it and walk away, money in hand. Even when you sell a house, typically you’ve moved on to something bigger and better and aren’t looking in your rearview mirror as you pull away. Such is not the case with seller financing a business, and for the uninitiated this can seem like a mighty big note to hold on to.

While I can certainly understand this concern of “I don’t want to be the bank,” you should be aware of at least three ways that holding the note on part of the purchase price of your company benefits YOU, the seller:

  1. You get a higher price for the business;
  2. You get a higher return on your investment after the sale; and
  3. You’ll get a quicker sale.

Get a Higher Price for Your Business

According to numerous independent analyses of sold businesses across a wide variety of industries, you can actually expect to get more for your business when offering seller financing. Toby Tatum reported in his book Transaction Patterns that with seller financing, sellers actually received 25% to 30% more for their businesses when he compared the sale prices of 2,703 cash deals and 1,262 deals that were seller financed. This is not just anecdotal evidence. I have seen it in my own practice and hear the same reports from colleagues in the industry. 

Candidly, no matter if you are selling your business to a Private equity Group or a strategic buyer even a high net worth buyer…. You will be asked to finance at least a portion of the purchase price.  SBA in 2009 make it mandatory for the seller to finance a portion of the purchase price unless there is some unique circumstances.  Certainly I am not talking about the outliers here.  In addition, Private equity more than they don’t require some type of financing.  YES I have seen it before be pretty low percentage… But the requirement still remains.  When I say requirement.  It is required in order for the buyer to feel comfortable buying your business over another one on the market.

You Get a Higher Return on Your Investment

When you fulfill 100% of the role of the bank, you have a great opportunity to earn far more money than with just the initial sale with The Power of Interest.

A basic understanding of how banks make money with interest will show you what I call “the power of interest.” When you take advantage of the opportunity to finance your business at 8% to 10%, you make what starts out as a good sale into a fantastic investment.

Here’s an example. If you finance $250,000 for a period of five years at 8%, you will receive an extra $54,145 on the note; financed at 10%, you will get an extra $68,705. There are few investments available these days that can reap that kind of return. 

Don’t forget that statistically you receive 30% more for the business by financing it rather than selling it for all cash; therefore, on an all-cash deal this note would be extra $192,307 to invest somewhere else. Therefore, to earn the same money on an all-cash deal as you would in a seller-financed deal, you will need to earn between 20% and 23% on your money. WOW! Where are you going to get that kind of payout? Real estate investments? Stocks?

Why not consider the VERY realistic to realize an 6% to 10% return on your investment when financing the sale of your own business. This is a great reason to be a financier of your business sale, especially in a rough economy times.

Get a quicker sale

If the above reasons weren’t quite enough to “sell” you on the prospect of seller financing, here’s one more reason to consider -- seller financing can also lead to a speedier sale. If the seller plays the role of the bank (where a bank isn’t involved at all), then the deal gets done more quickly (from saving time with the banking process to decreasing the sales process time because of increased buyer confidence). Applying for a bank loan takes a long time and is a meticulous process for both the seller and the buyer.

Banks simply will not loan money on a lot of quality businesses. Banks are asset lenders. They want to loan money on the actual tangible assets of the business. They don’t know you, they don’t know how great your business is.  By focusing on tangible assets, the bank has a quantifiable way to feel comfortable loaning the money, to make the loan look good on paper. Banks look for the SBA (small business administration) to guarantee the loans that go above the value of the assets.

However, with recent law changes even the SBA now limits the amount of money that it will allow the bank to lend. This is important to you as the seller because most buyers look to the bank to help in the purchase.

When a bank says that they will lend money only on the assets of the business, where does that leave the buyer? Because the bank takes this approach, the buyer feels that the business is only worth asset value; and as you and I both know, many times the value of your company is located in the “goodwill” or “going concern,” and the assets are just one component in a long list of valuable characteristics of your business.

It is important for you to play the role of the bank because it is becoming more and more difficult to get ANY business financed for a sale, much less a business that has (any conceivable kind of) a blemish associated with it.

In addition to the fact that it is difficult to get the business financed, banks move much slower than sellers, even when they do approve a loan. Banks take anywhere from 90 to 180 days to approve – and close – a loan.

Another downside of outside banks

Not only banks slow, the bank’s approach to value may minimize the perception of value in the eyes of the buyer. From my experience, even when a bank does approve a loan, bankers sometimes give the buyer negative feedback about the business, inducing the the buyer to back out. I know this sounds outrageous, but you would be surprised how many times that has happened just in my firm.

Seller financing provides confidence to buyers that you, in fact, have a good business, and staking your own money on that assurance. If you didn’t have a good business, then why would you offer a structured sale? It is one thing to say you have a good business and ask the buyer to put their life savings into your company to prove it, but is quite another thing for you to tell the buyer that you believe in the business enough that you will offer terms on the purchase.

Repossessing your business after a sale: not as bad as you might think

One common fear among business sellers considering seller financing when selling a business is the possibility, no matter how slight, that the buyer will default on the seller’s note and they will have to repossess the business and go through the entire sale process again.

It’s a fair enough concern.  After all, if you DID want to take the business back why would you be selling it in the first place, right? This isn’t some big box department store with a returns department where if you’re unhappy after selling your business, you get to take it back a few weeks later and get a full refund. This is real life, and in real life selling and buying businesses is a big, BIG decision. But let me help you make the right one by controlling the risk of this big decision.

Why is it that the thought of possible repossession of your business after a sale give you such heartburn anyway? Is it possible that you are burned out? What caused you to get into the business in the first place (however many years ago) is not where you are at today. You are selling your business for a reason. No one can blame you for not wanting to start all over again, coming out of retirement or whatever new venture you are on, and going back to the office, or the factory, or whatever. Don’t let burnout you are likely feeling (possibly the reason you are selling your business in the first place) lead you to make bad decisions about your financial future.

Certain businesses are hard to run, and you don’t want to take it back for a variety of reasons. But what are they? Before you accept this reason – “I don’t want to take it back” – as why you don’t want to get involved with seller financing, I want you to at least consider “why” you don’t want to take it back.

No, really.

Ask yourself, “Why don’t I want to take the business back?”

More specifically, ask yourself:

  • Are you burned out?
  • Do you want to try something else?
  • Are you fed up?
  • Are you afraid that you have hit the summit of what the business is able to do?

I asked this particular series of questions because when I sold my business, I turned to my business partner and said, “I hope he pays us for three years and then we have to foreclose. Even if he runs it into the ground, that’s fine.”

Why would I ever say such a thing? Because seriously, it didn’t bother me if he did run the business into the ground because I knew I had the monitoring and covenants in place to be able to step in before it was too late.

In fact, I saw this “three years and foreclosure” deal as a best-case scenario. I didn’t hat my business, I didn’t think it had tapped out of potential growth.  I just wanted a different Venture. Think about it. If the buyer paid me three years of principal and interest, it meant I could take it a little bit easy while I retooled for my next business venture.  If I then had to foreclose or exercise my rights with the “stock pledge,” and the buyer has signed a personal guarantee, the buyer would still owe me the money, but I would own the company again. I knew I would be able to step back in and take the company back to where it was before even if the buyer made a mess of things. Yes, this might be hard, but it’s well worth it. Why? Simple. I would sell it again.

Repossess, remodel, and resell is a proven business model in real estate, and also in other areas of business.

My grandfather taught me this about real estate: when you foreclose on a property, you take a portion of the money that they paid you and remodel the house. Then sell again. My grandfather did this repeatedly. Why? Because it worked. In fact, he made a lot of money with this business model.

No, I didn’t get the opportunity to foreclose on my high-end janitorial company, but if I had, I would have seen this as a win/win, not as a win/lose – as an opportunity to make more money, and not the other way around.

If your company is really ready to sell, then your company is not fragile. Meaning, an experienced and qualified buyer is very unlikely to “run” the business into the ground to the point that you have to take the business back.

I truly believe that most business owners could look at their business objectively and see that they could step back into the business (if monitored properly) and get the business back to the level of selling it quickly.

If you are still uneasy with this prospect, minimize the time of financing with bridge financing, lessening the period of time when things could go wrong. If you don’t want to have your money “tied up” for a long period of time and you certainly don’t want the business back, consider financing the business for a short period of time instead.

Consider a 24-month loan with a balloon payment at the end, called a bridge loan. This will limit the time of your “risk” of taking the business back over. This may be necessary to cover a short-term lending problem that the buyer may have in buying the business. This bridge loan will help “bridge” the gap for the buyer, the gap between the sales price you want and any bank limits on the amount that they can loan for the sale of a business. Its easier for the buyer to get the money to consolidate debt 24 to 36 months after closing.

Another option is to limit the amount of time that you carry the loan by “selling the note” to a note broker.

The fear of possibly having to take back your business in a seller financing default situation is, when carefully analyzed, not much of a reason at all. Safeguards exist in the seller-financing model that protect you from losing your investment in your own company.

Even if someone did step into your shoes, not fill them properly, run the company into the ground and have to turn it back over to you, what’s the loss? Okay, so you play golf a few less days a week until you build the company back up and sell it again. It really IS win/win, even if it’s just a tad more work.

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