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Sell a Business: Seller Financing Series: Determine the term of seller financed note

As you work with you business broker to plan the details of a sale, its good to have a overview understanding of how seller financing works because that is part of a majority of business sales.

If you are really interested in selling your business, then it is important to be mindful of the “competition” in the market for buyers. There are thousands of businesses for sale at any given time and many times a buyer looks at hundreds of businesses before finally choosing one. Though your business is unique, plan to have the terms of sale, and seller financing, be within the range of what a prospective buyer is seeing from other companies.

Amount of Down Payment

It’s not uncommon for a buyer to get a business for about 20% down, so if you considering seller financing, you should be as conservative as possible in asking for a down payment. It is typical to get one times your yearly earnings or seller’s discretionary earnings (“SDE” on the low end) to 50% of the purchase price down (on the high).

SDE is equal to the amount of “benefit” that you receive from the business each year. This number is more than the profit on your tax return or profit and loss statement. SDE is the total amount of money that you make or your benefit as the owner. A quality business brokerage firm can help you discover this number.

Interest Rate

A seller financed loan can have whatever interest rate the parties agree to, but remember that you are not a bank.  This is an investment to you.  Expect a much higher return on your money than you can get in most other investments, usually ranging from 2% above Wall Street Prime but no less than 6% and not more that 12%. (At the time of writing this book, prime is at 3.5%.) The bulk of the seller-financed businesses provide a return of 8% to 10%.

Some sellers, however, prefer to go with a more traditional bank approach and use a “variable interest” rate. For example, the interest rate could be Wall Street Prime + 2%, adjusted monthly, quarterly, or yearly based on the then current Wall Street Prime interest rate. Often there is also a floor and cap on the interest rate, such as not to go below 8% or over 12%.

Term of the Note

The term of the note is the length of time that a buyer has to pay the loan off, the period that the loan is “amortized.” There are several ways to determine the length of the term. A skilled business broker can walk through a process of analyzing the business current profit, the buyer’s living wage needs, rainy day fund, reasonable funds necessary to grow the business, and the amount reasonably available to service debt.

When selling a business, both the seller and the buyer want as much money as possible reinvested back into growing the company rather than taking the money out and weakening the company’s ability to pay. Therefore, the best way to have a “win/win” situation for the buyer and seller is to have a loan amortized for 10 years.  While the loan is amortized over 10 years, we typically set a balloon payment at month 61. Sometimes, according to the quality of the business and the condition of the financials, we will do a balloon payment at month 37.

Therefore (as you may already foresee), the bulk of the payments you receive for the first three to five years are in INTEREST. When the buyer makes the balloon payment, be it at month 61 or 37, it is not far off of the total amount being financed.

Payments

Depending on the type of business, it may be necessary to offer a varied payment schedule to account for a variety of business-specific variables. For example, if you are in a seasonal business like a heating, ventilating, and air conditioning (HVAC) company, it might be logical to have the payments due in the summer be higher than the payments due in the winter. Not only will this seem more realistic for you, but also it is important for buyers to be mindful of the ebbs and flows of cash for their business.

Try to arrange the seller note to be paid in the way and at the times that you know the business can be better positioned to pay it. You may actually tell the buyer that they make no payments for three months, but then you would spread out over the rest of the year or maybe schedule it such that during the height of the business season (when the coffers are full), they are actually making double payments.

Also, consider allowing the buyer to get into the business and “get their feet wet” before making payments. I usually recommend 60 to 90 days before the first payment is due. This will help the buyer “settle in” and deal with those various additional expenses that always occur after purchasing a new company, and build goodwill in your relationship.

Seller Earn Out

A seller earn out can be used AS the seller-financed portion or in addition to the seller note. An earn out is typically used in situations where the value of the company is really in the “potential” of the company rather than based on the “past” earnings of the company.

So, for instance, if you have a business that has just signed a multimillion-dollar contract right before closing, this might be a solution for you. In a situation where there is a seller earn out, the business has to make the money BEFORE the buyer is obligated to pay the amount. This type of loan is not amortized until the “target gross revenues” are met. So in the situation where you have already signed a contract for the “extra” earnings, this makes sense.

Seller earn outs are also used when we are trying to bridge the (sometimes considerable) gap between what a seller wants for their business and what the business is actually worth. Therefore, the business is sold on the “potential” of the future rather than the past.  There are times when a business has signed a large contract or there is some other situation that will cause the business to grow in the future without the involvement of the buyer. This means that IF the business does grow and accomplish what the seller claims that it will, then the seller gets an “earn-out” payment. Therefore, the sale price of the business is really based on the projections of the seller.

This is also used in situations when a business has had a downturn in profitability. In this scenario you, the seller, have the confidence that this is just a slight downturn due to external factors (or factors that you have taken care of). We put an earn out in place for the express purpose of getting the buyer to pay what the company was worth, all the while giving the buyer the confidence that the downturn was not long term and you are standing behind this claim.

Sell a business: Nuts and Bolts of Seller Financing

As you work with you business broker to plan the details of a sale, its good to have a overview understanding of how seller financing works because that is part of a majority of business sales.

If you are really interested in selling your business, then it is important to be mindful of the “competition” in the market for buyers. There are thousands of businesses for sale at any given time and many times a buyer looks at hundreds of businesses before finally choosing one. Though your business is unique, plan to have the terms of sale, and seller financing, be within the range of what a prospective buyer is seeing from other companies.

Amount of Down Payment

It’s not uncommon for a buyer to get a business for about 20% down, so if you considering seller financing, you should be as conservative as possible in asking for a down payment. It is typical to get one times your yearly earnings or seller’s discretionary earnings (“SDE” on the low end) to 50% of the purchase price down (on the high).

SDE is equal to the amount of “benefit” that you receive from the business each year. This number is more than the profit on your tax return or profit and loss statement. SDE is the total amount of money that you make or your benefit as the owner. A quality business brokerage firm can help you discover this number.

Interest Rate

A seller financed loan can have whatever interest rate the parties agree to, but remember that you are not a bank.  This is an investment to you.  Expect a much higher return on your money than you can get in most other investments, usually ranging from 2% above Wall Street Prime but no less than 6% and not more that 12%. (At the time of writing this book, prime is at 3.5%.) The bulk of the seller-financed businesses provide a return of 8% to 10%.

Some sellers, however, prefer to go with a more traditional bank approach and use a “variable interest” rate. For example, the interest rate could be Wall Street Prime + 2%, adjusted monthly, quarterly, or yearly based on the then current Wall Street Prime interest rate. Often there is also a floor and cap on the interest rate, such as not to go below 8% or over 12%.

Term of the Note

The term of the note is the length of time that a buyer has to pay the loan off, the period that the loan is “amortized.” There are several ways to determine the length of the term. A skilled business broker can walk through a process of analyzing the business current profit, the buyer’s living wage needs, rainy day fund, reasonable funds necessary to grow the business, and the amount reasonably available to service debt.

When selling a business, both the seller and the buyer want as much money as possible reinvested back into growing the company rather than taking the money out and weakening the company’s ability to pay. Therefore, the best way to have a “win/win” situation for the buyer and seller is to have a loan amortized for 10 years.  While the loan is amortized over 10 years, we typically set a balloon payment at month 61. Sometimes, according to the quality of the business and the condition of the financials, we will do a balloon payment at month 37.

Therefore (as you may already foresee), the bulk of the payments you receive for the first three to five years are in INTEREST. When the buyer makes the balloon payment, be it at month 61 or 37, it is not far off of the total amount being financed.

Payments

Depending on the type of business, it may be necessary to offer a varied payment schedule to account for a variety of business-specific variables. For example, if you are in a seasonal business like a heating, ventilating, and air conditioning (HVAC) company, it might be logical to have the payments due in the summer be higher than the payments due in the winter. Not only will this seem more realistic for you, but also it is important for buyers to be mindful of the ebbs and flows of cash for their business.

Try to arrange the seller note to be paid in the way and at the times that you know the business can be better positioned to pay it. You may actually tell the buyer that they make no payments for three months, but then you would spread out over the rest of the year or maybe schedule it such that during the height of the business season (when the coffers are full), they are actually making double payments.

Also, consider allowing the buyer to get into the business and “get their feet wet” before making payments. I usually recommend 60 to 90 days before the first payment is due. This will help the buyer “settle in” and deal with those various additional expenses that always occur after purchasing a new company, and build goodwill in your relationship.

Seller Earn Out

A seller earn out can be used AS the seller-financed portion or in addition to the seller note. An earn out is typically used in situations where the value of the company is really in the “potential” of the company rather than based on the “past” earnings of the company.

So, for instance, if you have a business that has just signed a multimillion-dollar contract right before closing, this might be a solution for you. In a situation where there is a seller earn out, the business has to make the money BEFORE the buyer is obligated to pay the amount. This type of loan is not amortized until the “target gross revenues” are met. So in the situation where you have already signed a contract for the “extra” earnings, this makes sense.

Seller earn outs are also used when we are trying to bridge the (sometimes considerable) gap between what a seller wants for their business and what the business is actually worth. Therefore, the business is sold on the “potential” of the future rather than the past.  There are times when a business has signed a large contract or there is some other situation that will cause the business to grow in the future without the involvement of the buyer. This means that IF the business does grow and accomplish what the seller claims that it will, then the seller gets an “earn-out” payment. Therefore, the sale price of the business is really based on the projections of the seller.

This is also used in situations when a business has had a downturn in profitability. In this scenario you, the seller, have the confidence that this is just a slight downturn due to external factors (or factors that you have taken care of). We put an earn out in place for the express purpose of getting the buyer to pay what the company was worth, all the while giving the buyer the confidence that the downturn was not long term and you are standing behind this claim.

Seller Financing Series: Protecting Your Seller Financing Investment With Covenants

You’ve worked hard to build your company, have it just the way you want it, and now that the time has come to sell it…well, you’re naturally concerned that the new buyer will come along and make a ton of new changes that may hurt the company. If you making a cash sale, this affects mostly your ego, but if you are providing seller financing (a very common situation), it feels like this would affect your ability to get paid.  This fear often keeps sellers from wanting to consider seller financing. How valid is this fear? What if the buyer makes a lot of changes? This could be a problem if we are talking about changes that have a significant effect, negatively speaking, on the business. It is not necessarily a problem, however, if the buyer comes in and makes changes that will GROW the business.

I know these statements are obvious at first blush, but we need to have this basic understanding of what change means. We don’t want the buyer to make WRONG changes. We want the buyer to make the RIGHT changes. We want the buyer to come in and do things that we were never able to do, that is, take the business to the next level. In fact, hopefully, this is one of your goals in the sales process.

One of the ways to avoid “bad” changes in your business while you are still invested in it via seller financing is by ensuring your buy-sell agreement contains covenants, written guarantees beyond personal guarantees, that help ensure you will get paid.

Legally speaking, there is an approach that we can take to make sure that the buyer does not make too many changes that will ultimately damage the business. This is called a covenant. A covenant is a promise commonly found in the form of restrictions in a loan agreement imposed on the borrower to protect the lender’s interest. For our purposes, a covenant is a promise in a formal debt agreement that certain acts will be performed and other acts will not be performed.

Covenants are used frequently in Mid-sized transactions and in the merger and acquisitions world where there is a “second” lender. This second tier lender typically doesn’t have a personal guarantee from the principals of the company, nor do they have a “first lien” on the company’s assets. They are called Mezzanine lenders. I bring this up not because you don’t have a personal guarantee or a first lien against the assets of the company but because having the proper covenants in place on the sale of your business is sometimes just as effective as a personal guarantee and first lien position.

There are many types of covenants, tailored to the unique circumstances of your business. A covenant should be practical and not unduly restrictive. It should be something that you could “live” with if you were the buyer. When developing the “right” covenants for your business sale that you make a list of the areas that you would be most concerned about a buyer “changing” once coming into the business. Here are a few.

One comment that I hear a lot when companies pass from hand to hand is “will the new owner fire all the employees?” Personally, I think this is funny. Why? Because one of the biggest concerns that most all buyers have is “Will the employees stay once the business is sold?”

In fact, this is so common that both the buyer and the seller have the same concern. But either way, to make sure your employees (or most of them) are protected once you’re gone, you could set a covenant stating that the buyer must maintain 50% of the current staff as long as the seller note is owed.

To be fair to the buyer, it is possible for an employee to leave the business after closing. It is also very possible that the buyer had nothing to do with the loss of this employee. So if you consider using this type of covenant, do so with the buyer’s input.

The next area of concern that I frequently hear about is when the buyer may change a policy that is the key policy for your success. Well, first off, think about that for a minute. If it is “that” important, then you should be training the buyer during the training period. Most buyers are not going to purposely make changes that will ultimately hurt the profitability of the company. But if you locate some of the areas that you feel are a problem if the buyer changes them, then certainly talk to the buyer about adding a covenant in the loan agreement.

I can’t emphasize enough the power of communication in this process. The more you are communicating about these areas that should NOT be changed, the less likely the buyer is going to change them. And if you are still concerned about them being changed (ahem, you may not have the right buyer), you can always put a covenant in the loan documents that prevent the buyer from making these changes.

Again, finding the right buyer will fix a lot of the problems associated with seller financing. This is why sellers should never sell their business on their own. When you sell the business on your own, you do not have the ability to “interview” enough qualified buyers to buy your business. It is important to find the RIGHT buyer, not just the first buyer – or the highest offer buyer.

What kind of covenants should you be putting in place? Certainly, there is likely a covenant for every issue under the sun – and not enough room for me to cover them all here! However, typical covenants on business sales include the following:

  1. Buyer is not allowed to move the location of the business until the note is paid off.
  2. Buyer cannot sell any asset (typically over $5,000) of the business without prior permission.
  3. Buyer must maintain a set “debt to equity” ratio (meaning percentage of debt versus income). This will make sure that the business is not so overburdened that the business can’t pay its typical bills – or even you!
  4. Buyer must maintain a certain number of staff members.
  5. Buyer salary could be limited to some predetermined yearly salary and NO dividends. While this is hard to enforce, it can be a motivating factor for the buyer to pay off the loan ASAP.
  6. Buyer must provide financials or other reports on a quarterly or yearly basis.
  7. Buyer can’t sell or issue more shares or change officers of their corporation.
  8. Buyer must submit a yearly business plan to the seller. 
  9. Buyer shall maintain its books, accounts and records in accordance with generally accepted accounting principles.
  10. Buyer must maintain proper insurance like General Liability and/or the exact same type of insurance you currently have.
  11. Buyer is required to provide seller with notice of any Litigation.
  12. Buyer is required to conduct business in generally the same manner as before the sale, for  example, buyer will not change the company name or the usual types of products or services it sells.

As I mentioned, these are just a few of the covenants you could include to protect yourself. Obviously, it is best to sit down and list out the important aspects of your particular business and the areas that would harm your business if they were changed. It is also important that these items are reasonable for the buyer.

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Dallas Business Broker, Mergers & Acquisitions Dallas / Fort Worth / Texas

214-396-8100 Office
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