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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.

Selling a business: Setting up your business buyer for success

As you prepare to sell your business, you need to think in terms of setting up the buyer for success. Inevitably there will be changes post closing- and many sellers worry that the buyer will want to make too many changes - but how can you avoid “bad” changes in your company, ones that could impair your new investment in a seller’s note?

Three Ways to Avoid “Bad” Changes in Your Business

How do we make sure that the buyer is going to make “good” changes and not make “bad” ones? There are three primary ways to guarantee this:

  1. Find the Right Buyer: As has been discussed in other articles, carefully screening for the right buyer, at the right time, for the right company goes a long way towards a successful outcome, and hiring the right business intermediary to assist in this process is invaluable.
  2. Make Sure The Buyer Has the Right Training: Most of the time, when the buyer makes changes that hurt the business, it is a direct result of their lack of understanding. Make sure that you stick around long enough – or have someone do so in your stead – to make sure that the buyer gets the right training so that all his or her changes are of the good kind.
  3. Make sure your agreement has strong and valid covenants: Covenants are the written guarantees beyond personal guarantees that establish some boundaries of permissible change and required affirmative actions that make success most likely.

Most of the time, when the buyer makes changes that hurt the business, it is not because they chose to do so purposefully. They have no interest in hurting their own business. Usually bad changes come due to a lack of understanding. This lack of understanding might have been corrected if the buyer had been properly trained before taking over the business.

Don’t leave it up to the buyer to initiate the process. Instead, you as the seller should take control of this process. Don’t be passive, either, and ask the buyer how much training they want. They may know what they want, but they don’t know how much they need.

When you are providing the financing for the business, you have an advantage over a bank providing financing. You have the ability to teach the buyer everything that they need to do in order to be successful. A bank cannot do this. In fact, most buyers want you to teach them. But most buyers are NOT going to ask you every question that they should and are NOT going to know how many hours of training that they should ask for.

This is an area that you and your business broker should determine from the very beginning and should be modified once a buyer is located. There is a simple process that you follow to create the training program. You have more things in your head that are true keys to your success and are virtually critical to future success. At my firm, we help you develop this “training program” or, as we call it, “unique process.”

Your Own Unique Process

It is called a “unique process” because this is how your company – and your company alone – does everything from payroll to purchasing, marketing to maintenance. It is a training program that allows anyone with common sense and maybe the slightest bit of technical knowledge (depending on your particular business) that they need to do it the “unique way” that your business does it.

For example, there are hundreds of thousands of janitorial businesses in America, and there may be thousands that clean apartments the exact same way that we did with my first business. (Well, not the “exact same way;” our business was successful because of our unique business approach). It was easy for me to train the new buyer because I was prepared to let him know, step-by-step, how the process worked, from procurement to completion, from how to clean a toilet to how to vacuum the carpet.

You may think to yourself, “Man, if they need to be told how to vacuum then maybe they shouldn’t buy a janitorial business in the first place.” Well, most people know how to clean a toilet or vacuum. But do most people know that the “lines” that are created when you vacuum can cost you hundreds of dollars in profit a day if not done properly? It is true, particularly in the challenging market this buyer was going to be taking over.

Without getting into TOO much detail about the janitorial business (that would take a whole other book), we had a separate charge for “touch-ups.” This was a charge for a particular property when we were required to come back to the property and clean up a mess that was made by a repair person who came in after us. Now, this might have been an inconvenience, but at least we got to charge for our services.

However, if my cleaners missed something, we had to “go back” to the property and correct the issue for “free.” So I quickly learned that it was best if my cleaners vacuumed the last thing before they left.  For example, if you have a property manager inspect the unit, make sure that you go back and vacuum every place the manager walked. This way, there are NO footprints left behind and no “touch-up” calls needed.

I even had my cleaners “back” their way out of the apartment. This may sound funny, except when I’d get a call to come “back” to correct something my cleaners “missed,” that is. With this policy in place, it was easier for me to show the property manager once I arrived that someone had been in the unit since we had left. It was a regular occurrence for us to get a call to go back and clean up the “sheet rock dust” that was on the floor.

When I sent my supervisor to the complex, he could point out to the property manager that you can clearly see the “vacuum lines” underneath where the sheet rock dust had fallen. While this may seem a little like CSI, it was crucial to the profitability of my janitorial business. Literally, we would profit hundreds of dollars a week more each and every week that we put this “little” policy in place.

These are the types of seemingly simple things that we learned over the time in developing our processes.  We refined the processes, sometimes through trial and error, resulting in part of the value of the business we were now selling.

Therefore, when I sold the business, to ensure that the buyer got at least the same value from the business that we had, I needed to make sure that the buyer knew full well “why” we vacuumed the way we did, how it could save him money and how not to “leak money” by ignoring this vital – and simple – process. If he didn’t understand this concept, he could easily change the policy when the teams complained about the extra five minutes that it sometimes cost them. The teams often missed the point that, sure, it may have cost them five minutes, but it saved the company hundreds of dollars.

Once the buyer understood this vacuum strategy and how it made him money, he could also see the value of me training him in my company’s specific protocols. Would you believe that, to this day, the janitorial business is still following this process? Sure you would, because it just plain makes sense.

Does Your Company Have Vacuum Strategies? Well, maybe not “vacuum strategies,” per se, but does it have “some” strategy that helps your profitability that a new owner would not immediately “pick up” on? In fact, you may not even realize or recall some of those strategies off the top of your head.

This is an area where a good business broker will help you really strip your company down to the brass tacks to make sure that no stone is unturned when it comes to training the new buyer with all the tools he’ll need to succeed.

To ensure that your buyer is properly trained in the operations of the business, you should make a list of everything that the business does. For instance, write down the answers to the following questions:

  • Who is responsible for each task?
  • And how, specifically – step-by-step if necessary – is each task completed?
  • Employees, vendors and clients – how do you work with each?
  • Who is the point person for each?
  • What special agreements do you have with each?
  • What are the best practices with each?

This may seem like busywork but, in fact, it is important to be detailed when handing over your company to someone new. It’s easy to miss something if you don’t strip the company down to the bottom and write these processes down from scratch. You don’t want the buyer losing an employee because you failed to let them know that an employee takes off every third Thursday.

It’s a little like baking a cake from scratch. Sure, your grandmother may know how to do it without consulting a recipe card, but could you tell someone how to do it without leaving out one single ingredient, step, temperature or detail? Not hardly; that’s why recipe cards – and unique processes – were invented!

This article is simply an outline of the process my firm uses everyday with our clients. We have a detailed system for how you develop a training process for your buyer. Many times a written, detailed plan is not necessary, but just as often it can help you, the seller, understand the “unique” processes your business follows every day that you forgot about. Many times you’ve been doing these processes so long you take them for granted, but leaving them out of the equation can leave your buyer empty-handed – and unprepared.

Take time before the actual sale of your business and “walk” through these steps so that you can have the confidence that when you finance your business the buyer is qualified AND trained for your particular business. It doesn’t matter if the buyer has more experience in the industry than you do (this is actually a common occurrence with buyers our firm locates) or if the buyer does not have more experience in the industry than you.

Regardless of how experienced he or she may be in your industry, you still have more experience at your particular business than the buyer. You understand the employees, vendors and clients; you know the details through and through.

To succeed, the buyer needs to understand every aspect of your business and how the business operates, especially the areas that your company operates differently from others in the industry – and how that difference is a competitive edge. Set them up for success!

Seller Financing series: What to do with debt when you are selling your business

Another obstacle you may think exists to selling your business is making sure the buyer puts down enough money to retire existing company debt.  I understand the concern.  I had the same quandary when I sold my own business. We owned six vehicles with a debt of about $120,000. It would have killed my chances of selling the business if, at closing, the buyer had insisted that I pay this off plus the other items that I “wanted” to pay off.

While there are many ways to handle these issues, we are going to discuss an option that will work in some instances -- a lease.

Here is what we did for my business, and I can often find something similar for your business sale.  It is/was called a lease. While we owed GMAC Financial Services $120,000, we turned around and leased those vehicles to the buyer for the same monthly fee as the monthly debt service. The lease we offered the buyer was for the same term, 48 months, as our debt with GMAC Financial Services; and at the end of the lease, the title of the vehicles would be transferred to the buyer with a dollar buyout.

Yes, you are still guaranteeing the note, but this still becomes a win/win situation. Consider that when I sold my business and since there was no bank involved in the sale of the business, if the buyer failed to make the payments to GMAC Financial Services, I could foreclose on the business EVEN if the buyer was paying my seller note perfectly. We put this into the loan documents as a covenant. The buyer paid monthly payments to escrow. The escrow company turned around and paid GMAC Financial Services. We used an escrow company for this so both the buyer and I could confirm with a third party that GMAC Financial Services was being paid on time. If the buyer was late on making a payment, then we were promptly notified by the escrow company.

Once the buyer went 30 days past due (before this time, I would have made the payment), I would foreclose. The “covenant” that we had in the paperwork didn’t allow for the buyer to “cure” or make the payment late. This meant that I would have simply owned the business again.

You can get creative with down payments too and you can do whatever you want when it comes to curing defaults. In fact, I now recommend for the seller to request that buyers pay a “down payment” on the lease. This down payment should be equal to two or three months’ worth of payments. The down payment is then paid directly to the lender – like GMAC Financial Services. When you use this method, if the buyer is a couple of days late, then it really isn’t a big deal since you have technically paid 90 days ahead.

I am NOT saying that you can do this in every situation, but you may be surprised at how many times this is possible. In fact, many times when you are leasing equipment, it is a simple application and phone call to get the lease into the buyer’s name. Also, I often see bank loans that are assumable.

I have been told by quite a number of sellers that “NO, my loan is NOT assumable.” And then after I review the loan documents and call the lender, guess what? It IS assumable after all!

Don’t let existing debt block the sale of your business.  Look at exactly what you owe and what options you have BESIDES paying the debt off. If you have a reputable firm representative that can help you (even with your lenders), it is possible to work out a deal with the lender (if they are unable to take you off of the loan) that you will stay on the loan for 12 months or 24 months. If the buyer pays on time, then your guarantee is terminated. This actually happens in a good percentage of the cases.

Also, look to see if the “debt” has a lien against the business and/or assets of the business. If it does not, it is possible that you are NOT required to pay off the loan when you sell. This can allow you flexibility when financing the business sale.

Yes, there is risk involved here. As the seller, you are still responsible for the original debtor, unless the lender takes your name off of the loan/lease. BUT if you think about it, the buyer is responsible to pay the loan and you have covenants in place to mitigate your risk.

Is it better to pay off all the debt or get your name off of the debt? Yes, of course. Don’t discount these methods, though; they may help you sell your business for the highest possible price while maintaining your equity.

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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

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