Understanding the importance of owner financing in deal structure
In being a business broker over the past 20 years, one of the issues I hear from owners starting to explore the selling process is that they will not consider taking any seller financing as part of the deal structure.
On this point, seller concerns are well taken. For example, why would an owner risk selling on owner financing to a buyer that they do not know? There is no way that the seller can tell if that buyer will be capable of handling the rigors of owning a business. What are the buyer’s week areas that may lead to the demise of the business? What about the new owner’s success during a severe economic downturn? Certainly, any of these issues could mean that after the business has been driven into the ground, the seller then gets back what’s left.
About a decade ago, the SBA started forcing or at the very least, “morally swaying” banks originating SBA loans to take a portion of the sale price in the form of subordinated owner financing. The customary amount of was 10% of the total sale price. Over time banks both SBA and conventional lenders have followed suite, requiring a standard minimum of 10% owner financing. The lenders rationale for requiring some owner financing is simple. If the banks new client gets in trouble with say, a supplier, or key customer of the former owner, then the seller will be motivated to chip in and assist with the issue. Having “skin in the game” as lenders refer to it means a higher degree of success for their client, the new owner.
The bottom line is this: In deals that have a sale price of $5M or under, owner financing will be involved in virtually every deal. Savvy owners should understand the importance of being flexible to a portion of owner financing to either getting 90% of the sale price from the purchaser’s bank, or not selling the company at all. It really gets down to that inevitability
Mary business owners do not get told the following before starting the process. The owner note will be subordinated to the overall primary note such as SBA or conventional. The bank will attach all of the seller’s assets to their primary loan not leaving any assets for security of the seller note. There will be SBA documents signed at closing by the seller, to the effect that in the event of default of the seller note that the seller cannot go after the buyer until the primary note is satisfied. Additionally, there may be a two year “standby” agreement to the seller note in which the seller only gets interest accrued during that initial loan period and then the amortization of P&I start.
Although these facts may be somewhat disheartening to many prospective buyers, there are things to remember. One is that the primary lender will turn the buyer inside out in their credit evaluation. The buyer will have to have pristine credit, no criminal or arrest record, a good business experience resume showing work experience that is expected to indicate successful business operation. Additionally, the buyer will have to have a minimum of 20% or more for a down payment and a balance in personal debt.
Most business owners may have forgotten that they started the business with no money, and developed the business out of sheer determination. The new buyer will have to have significant money to put down. And, before defaulting, the new owner will be answering to the bank on the primary loan having initially signed every document known in the banking world to secure the primary loan. It is therefore not just of the new owner in turning in the keys and walking away in the event of default.
Although a somewhat bitter pill to swallow, owner financing has its place in the modern buss acquisition world. Sellers can take some consolation that the primary lender will be thorough and “very binding” before the deal can get funded. The point is, before starting the selling process, business owners need to know the facts of the elements of deal structure to be better prepared.