A fact of the finance world today is that community oriented business banks are under tremendous financial pressure with more than 40 failing in the first quarter of 2010 alone (according to the FDIC). The reasons for this are numerous and well documented in the press; abundance of poorly performing real estate and small business loan portfolios, enhanced regulatory requirements, failure to provide services competitive with large banks (like mobile banking, online banking, ubiquitous branch access, etc.), and a general flee to safety by depositors. Even with the efforts by the Fed and the Feds to encourage small business lending, the actual velocity of loan activity continues to limp along at “depth of recession” pace.
In the midst of this, life goes on, and you want to sell your business. Your buyer wants to buy your business.
As it’s pretty much guaranteed that ambition exceeds cash, to make the transaction happen you are likely required to agree to some form of seller financing. That means that you, yes you, are the bank. So you need to act like a bank.
Whether you structure seller financing as an installment sale, an earn out, a term loan, or some combination of the above (which is a decision best made between you, a qualified CPA, and an M&A Advisor, Investment banker or Broker), the probability of ever seeing the cash associated with the financing is highly dependent on the strength of the buyer’s loan guarantees.
There are typically three levels of guarantee; cash flow financing, asset based financing, and personal guarantees. Let’s look briefly at each.
Cash flow financing is the typical way that small business sellers finance the sale of their business. Simply put, the buyer agrees to pay the seller over a period of time based upon the excess cash generated by the company. As you just convinced the buyer that the company will generate lots of excess cash (and that’s why they are buying), it is a little tough to turn around and say, “Uh, that’s not good enough.” But the truth is; that’s not good enough. Many, many things can happen that can quickly turn a profitable business unprofitable; the least of which is the transition between your steady hand and new ownership. In other cases, you and the new owner may dispute the profitability of the company once you have left – perhaps the new owner is “reinvesting” excess cash in the company as part of a growth plan, perhaps the buyer is running more personal costs through the business, perhaps salaries are adjusted upward to keep key employees. There are many ways that your cash heavy company might no longer be “able” to pay the loan. Once loan payments start being delayed, it is a never-ending battle to bring them back to current (think about delinquent tenants on rental property). If you stop at this level of guarantee, it’s fairly unlikely you will ever see all of your cash.
The second level of guarantee is to attach your financing to the assets of the company. Think about it this way; many small business owners manage their working capital requirements by bank financing Inventory and Accounts Receivable in their business. The reason banks are willing to do this is that these assets can be fairly easily assumed by the bank (well; the threat of having your inventory repo’d is usually enough to keep business owners honest on their payments as the alternative is an immediate shut down of their business). While it is unlikely that your buyer will agree to allow you to remain senior on Inventory and AR financing (which would limit his ability to finance w/a bank), it is not unusual to have the assets minus those just mentioned be pledged as a guarantee. In other words, if the buyer fails to make payments, then the seller can in effect reclaim ownership of the business. However, a clever and dishonest buyer can arrange an asset sale from himself to a new entity (even if owned by the new owner) and in the process create mayhem in your attempt to recover your payments. This is where it is critical to have a qualified attorney draft the guarantee language of your note.
The third level of financing is the personal guarantee. Many buyers have a misperception about what this actually means; it isn’t just a handshake that says if the business fails, the buyer will be personally responsible. Well, actually, it does say that – however, to be an effective personal guarantee, the guarantee needs to be attached to specific assets owned by the buyer; this is usually their house, their investment portfolio, certificates of deposit, etc. I usually suggest that you attach to assets that aren’t easily moved, and avoid assets like jewelry which can quickly disappear. When there are multiple partners buying into a business, it’s a good idea to designate a lead buyer whose assets are attached to the guarantee, and then require the multiple owners to work it out amongst after you’ve been paid.
Once you have the guarantees in place, you need to negotiate the interest rate and terms of repayment. I typically look at current SBA loan rates which can be found by calling your local community bank (assuming they haven’t shut down while you were reading this article), and then add a couple of points to cover the risk of holding a note tied to a single investment (as opposed to a diversified portfolio) and to cover the cost of having to recover your assets should the payments fail to materialize. There is a limit to what a buyer will accept, and as with every transaction – it’s a negotiation. Ultimately, you want to see the business succeed, and straddling them with usurious interest rates won’t contribute to that ambition.
I leave you with this final recommendation; a business transaction, in fact any transaction between people, requires a certain level of trust. A solid transaction starts by making sure you pull enough cash out on the front end to satisfy your current ambitions and goals with the understanding that all financing is Risky Business, and then trust your buyer has every intention to live up to his promise of repayment. Those guarantees are like life insurance; you want to have it, but never use it.