Jay Sachetti joined Jeff O’Brien, partner at Husch Blackwell and Dyanne Ross-Hanson, president of Exit Planning Strategies talked about the market for mergers and acquisitions, exit planning opportunities for companies that don’t end up for sale and how companies can maximize their eventual sale price during an early October panel at the first Upsize on Tap event at Summit Brewing Co. in St. Paul.
When the state Legislature passed a law requiring employers to provide paid leave and safe time for employees, Justin Bieganek started hearing differing details from friends, colleagues and peers.
business builder m&a
by Sandra Broekema
Every business owner who is thinking about selling wants 100 percent cash for the business. Why should you take the risk with a new owner who may not be successful taking over and running your business? If the buyer defaults on payments, you get the business back, probably in much worse shape than when you sold it!
That being said, the vast majority of small businesses sell with some level of seller financing, with really good reasons. Here’s why:
All-cash deals carry a significant discount. It is a simple matter of discounted cash flow. A single lump sum today is worth less than the sum of a series of future payments by the discount rate.
The discount rate reflects the time value of money and the risk associated with future payments. Most businesses sell with a 20 percent to 50 percent down payment and the balance financed over three to 10 years at an interest rate several points over prime.
Because almost all businesses sell with some seller financing, typical valuations and comparables are based on a term sale rather than all cash.
If a business is offered at an asking price of $1 million, an all-cash buyer will probably be able to purchase it for $600,000 to $750,000. Cash discounts on the order of 25 percent to 40 percent are common, reflective of five to 10 years of discounted cash flow at 8 percent to 12 percent.
If buyers must to go to a commercial lender to finance the business, they face more stringent loan qualification requirements and often a lengthy approval process. Lenders evaluate the creditworthiness of the buyer, and often require a stronger equity position (higher down payment) to reduce the risk of a failed buyer just walking away.
A bank will look to cash flow, tangible assets and a personal guarantee from the buyer to collateralize the loan. The standard debt service coverage ratio is 1.35, where the net cash flow is comfortably higher than the principal and interest payments, after a reasonable manager’s salary. Business and personal assets of the buyer can also be pledged to secure the loan.
Lenders usually link the seller to the future success of the business by requiring the seller to carry back a portion of the financing. This ensures the experienced seller will be committed to helping the buyer be successful. Small Business Administration guaranteed loans require at least 20 percent equity (which may be split between buyer down payment and seller financing). Seller financing is fully subordinated to that of the lender, with seller’s principal and interest payments being deferred for five years.
There is an aftermarket for seller financing and sellers can transfer their promissory note to a third party after the sale. Professional note brokers buy and sell promissory notes after 3 to 6 months of regular on-time payments (“seasoning”) with discounts ranging from 20 to 30 percent. Seasoning is required to reduce the risk of default by establishing a new owner’s record of making timely payments in full. Cash discounts are relatively high because of the time value of money and risk profile associated with these notes.
Red flag
If the seller is not willing to carry a note, it may send up a red flag to the buyer and the lender that there could be hidden problems in the business or in the industry that the experienced seller is trying to escape. It is in everyone’s best interest that the buyer will be successful in this new endeavor — your customers and employees depend on it. You must be convinced that the right buyer has the qualifications and experience to be successful, in addition to an acceptable financial offer.
Seller financing offers a higher rate of return than taking a lump sum and investing it in most alternative income-producing investments. Seller financing generally carries higher interest rates than commercial sources to reflect the higher risk and added convenience of faster approval and more flexible loan qualification.
The selling price is allocated to various classes of assets that will impact the tax implications for both parties. Most transactions involve owner training and some level of ongoing consulting, which can be spread over time as ordinary income for the seller and a regular business expense for the buyer.
Now that you know the facts, it is your decision whether to offer terms (with the inherent risk and reward) or take the discount on an all-cash deal.
