Should I Finance All of Part of the Sale of My Business??
Very frequently in Mergers & Acquisitions, the seller finances part of the purchase price. The amount they finance may be anywhere from 0% to 100% of the deal. Typically, this is called Seller Financing, Seller Note, or Seller Carryback. Most business sellers are opposed to carrying any of the debt until they fully understand the benefits and drawbacks of such an arrangement. This is especially true in sub $10MM transactions.
Drawbacks to Seller Financing
The downsides to seller financing are pretty obvious. The seller is retaining some amount of the risk that the business might falter, while retaining only a small portion of the upside of the business. The other major downside is that if the seller finances a very large portion of the sale, 90% - 100%, they may feel as if their buyer doesn't have enough skin in the game or fully appreciate the asset the business represents.
Positives of Seller Financing
1. Price of the Business
The primary benefit of seller financing is that a seller can generally command a much larger purchase price for their business if they're willing to finance a portion. Even carrying 5%-20% of the purchase price can have the benefit of making the business acquisition more attractive to lenders. Lenders tend to feel more secure in a business loan that has seller financing because they believe the seller will be more likely to lend a helping hand if the buyer needs it. It also shows that the seller believes in the future of the business. It isn't uncommon that the increase in business value (in real dollar terms) is actually larger than the portion carried by the seller. Therefore, the cash at closing may be the same or larger to an owner willing to carry a portion of the sales price.
2. Finding the Right Buyer While Widening the pool
Another benefit of seller financing is that it may increase the potential buyer pool and allow the seller to be more choosy in selecting who is going to carry on their legacy. A key employee, or other individual, may be best to steward the business into the next generation, but not have the resources to purchase the business outright. Often, the continuation of the legacy and the continued employment of the people who helped build the business to what it is, is as important to a seller as the cash received from the sale. For this reason, a seller might be motivated to figure out how to make the right person the next CEO of their business and be interested in carrying a greater portion of the debt.
Financial Worth Related to Down Payment
There’s a saying we like to use around Optimum Transitions by Dillon, Ltd. That is, “My Price, Your Terms; Your Terms, My Price”. When we say this, what we’re really saying is that price and terms work together in determining the attractiveness of a deal to each party. If a buyer is paying all cash, it is expected that there will be a discount for a cash purchase. If a seller retains some of the risk (which we could have an entire article on different ways that can look) then the seller is going to expect a premium price. Focusing exclusively on price or certain terms allows oneself to be blind to the bigger picture. Quite simply, the business is worth more with more attractive payment terms.
Interestingly, the buyer with the least down payment is often willing to pay the most for the business. There are several factors at play here, but buyers with smaller down payments frequently have lower take-home earnings expectations. Because they can (and expect to) draw a smaller salary from the business for their typical expenses, they’re able to put more of the business’s cash flow toward debt service, thereby allowing them to pay a greater price for the business. Because of this, a seller has increased the potential buyer pool and the laws of supply and demand indicate that as demand goes up and supply stays the same, the price will go up. A larger buyer pool implies more demand.
In addition, one of the most important factors in selling your business is finding the right buyer. By increasing the pool of potential buyers by reducing the down payment requirements, a seller can be pickier about who acquires the business. This means the seller has a greater ability to choose a buyer who has the best: vision for the future, drive, talent, business sense, alignment of vision, people skills, or whatever factors are important to the seller.
Excuse to Stay in Touch
A seller may want to stay connected to the business in some form after the sale. A seller carry note can be a great excuse to stay in touch with the buyers of the business, and potentially even receive periodic business health reports. This can give a seller some peace of mind in knowing that things are going well.
Consider:
How Much, What Terms, Special Terms, Protections
Considerations in Seller Financing
1. How Much
The answer to this question will be different for every situation, but most lenders like to see a seller carry portion in the range of 5%-20%. This will depend on several factors including: the strength of the business, the strength of the balance sheet, and the strength of the buyer. Often the financial needs of the seller may also be a consideration. In some cases, the seller note can even count toward the “down payment” the lender is using to qualify the loan.
2. What Terms
Typically, a seller carry note is 5 to 10 years. Sometimes, to help the new owner get started, there is a payment deferment period of anywhere between 2 years and the full 10 years. But even when payments are deferred, the principal due is earning interest. The interest rate tends to be quite competitive in the marketplace. If the bank is financing the deal at 8% interest, for example, the seller might also expect around 8% fixed interest as well. Of course, all the terms are up for negotiation. This can create a win-win situation because the buyer is paying no more interest than they would through other sources, but the seller is getting a much better interest rate than they could find in other fixed income investments such as bonds or CDs.
3. What Special Terms
A seller needs to think about any special terms they need to feel comfortable with carrying a portion of the debt. It is reasonable to see a business plan from the buyers, and potentially even request annual or quarterly financial statements. In some cases, the seller might also be interested in reviewing a credit report on their buyers. They are extending credit after all.
You, the seller, have run the business successfully for many years. You might want to be in a position to help out if things are not going well under the new owner. You could consider a term in the contract that requires some sort of compensated or uncompensated consulting services in the event the buyer is in technical (or real) default with the lender or you. Of course, you cannot require the seller to follow your recommendations, but at least you will have a chance to provide the guidance.
4. Protections
The assets of a business tend to be already encumbered by the bank so they don’t make good collateral for the Seller Note. The seller can, however, request a personal guarantee from the buyer. Meaning that even if the business goes bankrupt, as long as the buyer doesn't go bankrupt, there is still someone to collect against. Lastly, it needs to be determined what happens if the buyer is in default. The bank may limit the actions of the seller in the case of default. Options in default may include acceleration of the balance due, increased/penalty interest rates, or late fees.
Bottom Line
Seller financing can create a beneficial situation for both the seller and the buyer. The seller's attorney and Mergers and Acquisitions Advisor will help guide the process of determining what terms, special terms, and protections make sense and help negotiate an agreement between the buyer and the seller. In Mergers and Acquisitions there is never a one size fits all solution, but taking seller financing completely off the table as an option often works against the seller accomplishing their goals in the business sale. If you're thinking about selling your business and would like expert advice to help with talking through seller financing and all of the other nuances of business transitions, please contact us. We're happy to help.
