Business sales are rarely completed without some financing. Therefore, you will need to know where the investor will get the money to buy the business. Generally, the money will come from third-party financing, seller financing, or a combination. Knowing what you are getting into if you finance any part of the sale is essential.
Seller financing involves up to 90 percent of small business sales and over half of mid-size sales. If you are not willing to finance at least some of the price, you may not be able to sell your company. The other option is for the buyer to obtain third-party financing. If the buyer is planning to obtain outside funding, the bank or other lender should confirm to you that the buyer is qualified and that the lender is willing to come up with the money before negotiations go too far.
Using outside lenders to finance the sale
When an outside lender, such as a bank or investment firm, finances the purchase of a business, the transaction is frequently called a leveraged buyout or LBO. LBOs were once very common, but many lenders have been stung as buyers tended to default when things got tough or had such difficulty making payments that lenders were forced to restructure the loans. Lending criteria are now stricter, and buyers are expected to put up more of their own money (or find a partner willing to).
In the small business context, the typical LBO buyer is one or more of your managers or key employees who wants to take over after you retire. It may also be a combination of managers and other investors. Sometimes it may be your children or a group of them. Having outside lender finance the transition of your family business to the next generation is an excellent way to transfer some of the risks outside your family if you find an institutional lender willing to participate. Institutional lenders are more likely to approve loans where the buyers already have experience in the particular business, so there will be a measure of management continuity.
LBO financing usually includes loans, equity interest
LBO financing is usually a package that combines several types of loans, as well as equity. The components may even come from different sources. The package may be put together by a bank, a commercial finance company, a venture capital firm, or mergers and acquisitions intermediary with access to capital markets.
Some typical components of the package might be 15 to 25 percent equity, 10 to 50 percent subordinated debt, and 40 to 70 percent senior debt. “Equity” would usually be in the form of common or preferred stock held by the buyer or by other investors such as venture capitalists. “Senior debt” would be loans on assets such as receivables and inventory (for asset-based financing) or real estate and equipment (for more conventional financing). The senior debt holder is a secured lender who stands in the first position to collect against the particular asset if the buyer defaults.
In contrast, “subordinated debt,” also called mezzanine debt, is akin to a second mortgage. If the buyer defaults, the debt holder will collect only after the senior debtors have been paid off. Consequently, the subordinate lenders frequently want a higher interest rate and an equity interest in the business, so there is a potentially greater reward in exchange for the greater risk they take in making the loan.
As you can guess, the complexity of the structure and the players involved make a typical LBO an unlikely prospect for the average small business unless you are in an industry that is considered attractive at that moment. However, the LBO model can work for even a tiny business if you are willing to act as the subordinate debt holder. The determining factor would be whether the business has sufficient assets and cash flow to interest one or more institutional lenders in making the senior loan(s).
The buyer may have lined up a bank to do the direct financing on the deal and may want you to take back subordinated debt for the remainder of the price in a variation of a leveraged buyout (LBO). In that case, you are second in line if the buyer defaults on the primary loan.
This is not as desirable a position for you, and if you agree to it, you should demand a higher interest rate. You should also consider continuing to maintain an equity position in the company, so that you have a voice (even if not the controlling voice) in the company’s management.
If your buyer wants to do an LBO, recognize that it will require a lot of work on your part to make it happen. These deals are neither simple nor straightforward and take time to put together. Not only will you need to cooperate with the lender, but you may also need to help sell the lender on the deal. However, the result can be significantly less risky to you than if you had financed the entire purchase yourself.
When should you consider seller financing?
Should you finance a buyer who is purchasing your business? There are pros and cons to seller financing. On the downside, if you allow the buyer to pay you off slowly over time, you will retain many risks from continued ownership of the business while giving up control of its management.
In most cases, the buyer’s ability to make the payments will depend on the business’s future success, yet your buyer may know little about your company, your customers, or even your industry. The buyer can mismanage your company down to nothing very quickly if you do not keep an eye on him. If the buyer runs aground and stops making payments, your only real recourse may be to foreclose on the note and repossess the business, but that means you will have to find another buyer and start over again.
On the upside, carrying back a note for some or all of the purchase price may be the only way to sell the business since banks have relatively strict lending criteria for acquisition loans. Moreover, seller financing can provide a tax break if you qualify for instalment sale treatment. For the buyer, seller financing can be a godsend because you will generally have more relaxed qualification standards and more lenient terms than a bank.
Seller financing can take a variety of forms
The simplest way to provide seller financing is to have the buyer make a down payment, with you taking a note or mortgage for the rest of the purchase price. The business itself and the significant business assets provide the note’s primary collateral. A lien on the property is filed with the governmental or official department or office, so the world knows it exists. If the buyer defaults on the note, you will be the first in line to step back in and take over the business.
In addition to its simplicity, this deal can be very flexible — you can adjust the payment schedule, interest rate, loan period, or any other terms to reflect your needs and the buyer’s financial situation. For example, you can provide a floating interest rate or one that starts low but goes up gradually over time.
Most seller financing will be for a relatively short term (say, five to seven years) but will be amortized over a much longer payment schedule so that at the end of the loan term, there is still a large portion of principal remaining. The buyer will have to obtain outside financing to pay off the loan balance in a “balloon” payment at the end of the loan period. The idea is that the business will be on a solid footing at that point, and bank financing will be easier to find.
Make sure to protect your interests
If you agree to finance part of the deal, you should try to get the buyer to provide more security for the loan besides the business itself. For example, you might require the buyer to put up a personal residence as additional collateral (assuming there is significant equity in the home.) Some buyers have other commercial real estates or investments that can provide more security.
You can also require the buyer to personally guarantee the loan, just as a commercial lender would. And, of course, you will want to thoroughly check out the buyer’s background, including credit record, management experience, personal assets, and character, just as the buyer will check you out during the due diligence phase of negotiations.
To further protect yourself, you should require the buyer to take out a life insurance policy with yourself as a beneficiary so that the loan will be paid off if the buyer meets an untimely demise. If the buyer is actively working in the business, you might also consider requiring disability insurance on the buyer, although sometimes this is prohibitively expensive.
Your sales contract may also restrict the new owner’s sale of assets, acquisitions, and expansions until the note is paid off. You may specify that you get to see the quarterly financial statements to keep tabs on the business.
Instead of financing per se, particularly if you’re being asked to put up-secondary financing to a bank’s acquisition loan, you might be able to have the buyer purchase an annuity contract for you or purchase some zero-coupon bonds. These are sold at a deep discount off of their future value. With this approach, the buyer gets the benefit of a lower payment now, but you would not be so dependent on their future success. This plan works best when you suspect you have a well-qualified buyer who could pay cash for the business but does not want to tie up all his funds there.