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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.

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.

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Sigma Mergers & Acquisitions LLC: 18170 Dallas Parkway, Suite 203, Dallas, Texas 75287
Dallas Business Broker, Mergers & Acquisitions Dallas / Fort Worth / Texas

214-396-8100 Office
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