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Seller Financing: The Basics

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Seller financing has always been a mainstay of business brokerage.  Buyers don’t have the capital necessary to pay cash, are unable to borrow the money, or are reluctant to use all of their capital.  Buyers also feel that a business should pay for itself and are wary of a seller who wants all cash or who wants the carry-back note secured by additional collateral. What sellers seem to be saying, at least as perceived by the buyer, is that they don’t have a lot of confidence in the business or in the buyer or perhaps both.  However, if you look at statistics, it’s apparent that sellers usually receive a much higher purchase price if they accept terms.

Studies reveal that, on average, a seller who sells for all cash receives only about 80 percent of the asking price.  Sellers who are willing to accept terms receive, on average, 86 percent of the asking price. The seller who asks for all cash receives, on average, a purchase price of 36 percent of annual sales while the seller who will accept terms receives, on average, 42 percent of annual sales.  These are compelling reasons for a seller to accept terms.  Business brokers have long been aware that reasonable terms are necessary if sellers are serious about selling their businesses.

The primary reason sellers are reluctant to offer terms is their fear that the buyer will be unsuccessful.  If he or she should stop making payments, the seller will be forced to take back the business, hope that the buyer can resell the business, or forfeit the balance of the note.  Another reason is that sellers feel that they can do more with cash than with the receipt of monthly payments. How often do sellers say that they need cash so they can buy another business?  That is probably not the real reason, but selling their business (or house) may be the only time that they can get a “chunk of cash.”  A business broker can help alleviate these fears by pointing out some of the ways sellers can protect their investment and by explaining some of the advantages of carrying the balance of the purchase price.  Equally important is how the deal itself is structured.

Let’s first take a look at the advantages to the seller of financing the sale:

  • The chances of the business actually selling are much greater with seller financing.
  • The seller will achieve a much higher price for the business with seller financing.
  • Most sellers are unaware of how much the interest can increase their actual selling price. For example, a seller carry-back note at 8 percent carried over nine years will actually double the amount carried.  $100,000 at 8 percent over a nine year period results in the seller receiving $200,000.
  • With interest rates currently low [at this writing], sellers can get a much higher rate from a buyer than they can get from any financial institution.
  • Sellers may also discover that, in many cases, the tax consequences of accepting terms are a lot more advantageous than those on an all-cash sale.
  • Financing the sale tells the buyer that the seller has enough confidence that the business will, or can, pay for itself.
  • The seller may be able to borrow some cash using the note and security agreement as collateral.  It may not be as easy as borrowing against real estate notes, but it’s still better than nothing.

Photo Credit: Iman Mosaad via Compfight cc

What Would Your Business Sell For?

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There is the old anecdote about the immigrant who opened his own business in the United States. Like many small business owners, he had his own bookkeeping system. He kept his accounts payable in a cigar box on the left side of his cash register, his daily receipts – cash and credit card receipts – in the cash register, and his invoices and paid bills in a cigar box on the right side of his cash register.

When his youngest son graduated as a CPA, he was appalled by his father’s primitive bookkeeping system. “I don’t know how you can run a business that way,” his son said. “How do you know what your profits are?”

“Well, son,” the father replied, “when I came to this country, I had nothing but the clothes I was wearing. Today, your brother is a doctor, your sister is a lawyer, and you are an accountant. Your mother and I have a nice car, a city house and a place at the beach. We have a good business and everything is paid for. Add that all together, subtract the clothes, and there’s your profit.”

A commonly accepted method to price a small business is to use Seller’s Discretionary Earnings (SDE). The International Business Brokers Association (IBBA) defines SDE as follows:

Discretionary Earnings – The earnings of a business enterprise prior to the following items:

  • income taxes
  • nonrecurring income and expenses
  • non-operating income and expenses
  • depreciation and amortization
  • interest expense or income
  • owner’s total compensation for one owner/operator, after adjusting the total compensation of all other owners to market value

Here are some terms as defined by the IBBA:

  • Owner’s salary – The salary or wages paid to the owner, including related payroll tax burden.
  • Owner’s total compensation – Total of owner’s salary and perquisites.
  • Perquisites – Expenses incurred at the discretion of the owner which are unnecessary to the continued operation of the business.

Developing a Multiplier

Once the SDE has been calculated, a multiplier has to be developed. The following (just as a guideline) should be rated from 0 to 5 with 5 being the highest. For example, if the business is a highly desirable business in the current market, “desirability” would be rated a 4 or 5. If the business is in an industry that is quickly declining or nearly obsolete, “industry” would be given a 0 or 1 rating.

  • Age: Number of years the seller has owned and operated the business.
  • Terms: Is the seller willing to offer terms?  For example, will the seller accept 40 percent as a down payment with the seller carrying back 60 percent at terms the business can afford while still providing a living for the buyer?
  • Competition: Consider the local market.
  • Risk: Is the business itself risky?
  • Growth trend of the business: Is it up or down?
  • Location/Facilities
  • Desirability: How popular is the business in the current market?
  • Industry: Is the industry itself declining or growing?
  • Type of business: Is the business type easily duplicated?

The average business sells for about 1.8 to 2.5. Obviously, if the SDE is solid and the multiple is above average, the price will be higher. Keep in mind that the price outlined includes all of the assets including fixtures and equipment, goodwill, etc. It does not include real estate or saleable inventory. The price determined above assumes that the business will be delivered to the buyer free and clear of any debt.

Veteran Wisdom

When all else fails, the words of a veteran business broker will work.

Asking Price is what the seller wants.

Selling Price is what the seller gets.

Fair Market Value is the highest price the buyer is willing to pay and the lowest price the seller is willing to accept.

Sellers should keep in mind that the actual price of a small business is about 80 percent of the seller’s asking price.

 
Photo Credit: kenteegardin via Compfight cc
 

Business Valuation: Do the Financials Tell the Whole Story?

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Many experts say no! These experts believe that only half of the business valuation should be based on the financials (the number-crunching), with the other half of the business valuation based on non-financial information (the subjective factors).

What subjective factors are they referring to?  SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats – the primary factors that make up the subjective, or non-financial, analysis. Below you will find a more detailed look at the areas that help us evaluate a company’s SWOT.

Industry Status – A company’s value increases when its associated industry is expanding, and its value decreases in any of the following situations:  its industry is constantly fighting technical obsolescence; its industry involves a commodity subject to ongoing price wars; its industry is severely impacted by foreign competition; or its industry is negatively impacted by governmental policies, controls, or pricing.

Geographic Location – A company is worth more if it is located in states or countries that have a favorable infrastructure, advantageous tax rates, or higher reimbursement rates.  A company with access to an ample educated and competitive work force will also enjoy increased value.

Management – A company with low turnover in management and a solid second-tier management team comprised of different age levels is also worth more.

Facilities – A company operating profitably at 70 percent capacity is worth more than a company currently near capacity. Equipment should be up to date and any leases – either equipment or real estate – renewable at reasonable rates.

Products or Services – A company is worth more if its products or services are proprietary, are diversified with some pricing power, and have, preferably, a recognizable brand name. In addition, new products or services should be introduced on a regular basis.

Customers – A company is worth more if there is not heavy customer concentration, but rather recurring revenue from long-time, loyal customers, as well as from new customers created through a regular and systematic sales process.

Competition – A company not contending head to head with powerful competitors such as Microsoft or Wal-Mart will rate a higher value.

Suppliers – Finally, a company is worth more if it is not dependent on single sourced key items or items available from only a limited number of suppliers.

 

Copyright 2012 Business Brokerage Press, Inc. 

Do You Have an Exit Plan?

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“Exit strategies may allow you to get out before the bottom falls out of your industry. Well-planned exits allow you to get a better price for your business.”

From: Selling Your Business by Russ Robb, published by Adams Media Corporation

Whether you plan to sell out in one year, five years, or never, you need an exit strategy. As the term suggests, an exit strategy is a plan for leaving your business, and every business should have one, if not two. The first is useful as a guide to a smooth exit from your business. The second is for emergencies that could come about due to poor health or partnership problems. You may never plan to sell, but you never know!

The first step in creating an exit plan is to develop what is basically an exit policy and procedure manual. It may end up being only on a few sheets of paper, but it should outline your thoughts on how to exit the business when the time comes. There are some important questions to wrestle with in creating a basic plan and procedures.

The plan should start with outlining the circumstances under which a sale or merger might occur, other than the obvious financial difficulties or other economic pressures. The reason for selling or merging might then be the obvious one – retirement – or another non-emergency situation. Competition issues might be a reason – or perhaps there is a merger under consideration to grow the company. No matter what the circumstance, an exit plan or procedure is something that should be developed even if a reason is not immediately on the horizon.

Next, any existing agreements with other partners or shareholders that could influence any exit plans should be reviewed. If there are partners or shareholders, there should be buy-sell agreements in place. If not, these should be prepared. Any subsequent acquisition of the company will most likely be for the entire business. Everyone involved in the decision to sell, legally or otherwise, should be involved in the exit procedures. This group can then determine under what circumstances the company might be offered for sale.

The next step to consider is which, if any, of the partners, shareholders or key managers will play an actual part in any exit strategy and who will handle what. A legal advisor can be called upon to answer any of the legal issues, and the company’s financial officer or outside accounting firm can develop and resolve any financial issues. Obviously, no one can predict the future, but basic legal and accounting “what-ifs” can be anticipated and answered in advance.

A similar issue to consider is who will be responsible for representing the company in negotiations. It is generally best if one key manager or owner represents the company in the sale process and is accountable for the execution of the procedures in place in the exit plan. This might also be a good time to talk to an M&A intermediary firm for advice about the process itself. Your M&A advisor can provide samples of the documents that will most likely be executed as part of the sale process; e.g., confidentiality agreements, term sheets, letters of intent, and typical closing documents. The M&A advisor can also answer questions relating to fees and charges.

One of the most important tasks is determining how to value the company. Certainly, an appraisal done today will not reflect the value of the company in the future. However, a plan of how the company will be valued for sale purposes should be outlined. For example, tax implications can be considered: Who should do the valuation?  Are any synergistic benefits outlined that might impact the value?  How would a potential buyer look at the value of the company?

An integral part of the plan is to address the due diligence issues that will be a critical part of any sale. The time to address the due diligence process and possible contentious issues is before a sale plan is formalized. The best way to address the potential “skeletons in the closet” is to shake them at this point and resolve the problems. What are the key problems or issues that could cause concern to a potential acquirer? Are agreements with large customers and suppliers in writing? Are there contracts with key employees? Are the leases, if any, on equipment and real estate current and long enough to meet an acquirer’s requirements?

The time to address selling the company is now. Creating the basic procedures that will be followed makes good business sense and, although they may not be put into action for a long time, they should be in place and updated periodically.