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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: 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.

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.

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