It is important for business owners that are getting prepared to sell their company to become familiar with the common financing structures that both buyers and lenders will require. In the present economic climate, sellers are no longer in the drivers seat to demand that a deal be structured they way the seller wants. Knowledge of how financing options will fit into the overall picture and being flexible to these options can make the difference if a deal will ever reach the closing table.
Below are the two most common methods to finance a business sale.
I have consulted with hundreds of business owners over the years and usually, one of the first things an owner will tell me, is that they will not agree to any owner financing. While it is understood that a seller either gets all cash at closing or there will be an element of risk, with today’s economic climate, owner financing will be an element in a majority of business sales. Both buyers and lenders will be looking to the seller to take back some paper in the deal.
The SBA, which is the most frequently used financial institution in business sales, will currently not do an SBA loan unless the seller takes back (a loan) for at least 10% of the total sale price. In fact, currently, I am seeing up to 20% owner financing being asked by many underwriters in SBA transactions. The length of the resulting seller note will need to be of the same duration as the SBA note, which is usually 10 years.
In most small business sales, the seller note will be unsecured, with the seller in a “standby” status not having recourse in the event of a default until the SBA loan has been satisfied. Many sellers are in the baby boomer generation, and a seller note of 10 years is not palatable; however, if selling is the primary goal, business owners will need to get adjusted to this scenario.
Owner financing has risks; no question. It becomes necessary, therefore, to sell to the right buyer. Fortunately, there are available buyers for most good business opportunities, and sellers frequently have a choice on which buyer to take for the deal. In many instances, the best acquirer for the business is not the buyer with the strongest financial profile.
Conditional performance notes
Simply stated, this type of note is based on the business performing financially to a predetermined base number called, “a benchmark” to pay the note. For example, if the gross profit reaches the “benchmark” in each quarter after the sale, the seller gets his note payment. The seller gets a percentage payment based on the level of the benchmark amount attained in that quarter.
An earnout note is actually a “bridge” financing structure between what the buyer is willing to pay and what the seller requires for a sale price. It is a guarantee to the buyer that he will not have to pay for the earnout amount until the business has performed in a period of time. Earnout notes are common in M&A deals and are an excellent way to bridge the gap between the parties.
Sellers want as much as they can get at closing, and buyers, regardless of their financial strength, usually want as much “leverage” as they can get in the transaction. The old adage of using other people’s money comes into full play in determining the amount of down payment. Even if a buyer is very well financed, or the acquiring company is much larger than the target acquisition, “the less down as possible” will be the buyer’s watchword.
If most sellers had their way, every deal would be all cash at closing. All cash deals do get done on occasion, but a general rule is, that the discount structure for an all cash deal is at a minimum of a 50% discount over the same deal with terms.
In addition, pledged security for future note payments is usually not available, or not agreed to by the buying public. The lending bank will be in a first security position after closing automatically putting the seller in second position. As such, the general rule of thought in a business acquisition is, that the business being purchased has to stand on its own to fund or “make” the deal
Deal structure plays a key roll in almost every business sale. It is therefore important that business owners become familiar with these financing methods and be flexible to fit them into their financial picture in order to sell their company.