Seller Financing and Earn-Outs
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Facilitating Business Sales

The Meeting

Jim stopped by my office one day with a thorny problem.

He owned a specialized manufacturing firm with a strong niche market presence. Jim had built his business for many years, transforming it from a small workshop into a significant player in the regional market.

Since he was approaching retirement, he had decided it was time to sell and enjoy the fruits of his labour.

Jim expressed his frustration. He had an accurate understanding of the business's value and its growth potential. Still, the soft market conditions made buyers cautious. Many were bargain shopping and unwilling to commit to his asking price.

Jim was considering lowering the price, but I could see that this would not reflect the true worth of his business or the opportunity it represented. So, I introduced him to the concept of seller financing, with a twist: an earn-out agreement.

I explained to Jim that seller financing could make his business more attractive to buyers struggling to find traditional financing. By becoming the lender, Jim could offer terms to make the purchase more accessible. Moreover, by incorporating an earn-out, Jim could tie a portion of the sale price to the business's future performance, addressing his concerns about buyers undervaluing the business's potential.

The earn-out would work like this: Jim would receive an initial sum upon the sale's closing, with additional payments to follow based on the business achieving specific financial targets over the next few years. This structure meant that if the company performed as well as Jim believed it would, he would ultimately receive his full asking price, perhaps even more.

Jim's eyes lit up as he grasped the possibilities. This approach provided a path to sell his business at a fair value. It mitigated the buyers' risk, making the deal more appealing in a hesitant market.

We helped Jim to negotiate a successful deal, working with his lawyer to ensure a comprehensive, well-documented agreement.

What is Seller Financing?

Seller financing allows a buyer to purchase a business without qualifying for a bank loan. (It's often called owner financing.)

The seller lends money to the buyer so the buyer can afford to purchase the business. Then, the buyer pays the seller back, usually with proceeds from the business.

Both parties negotiate the financing terms as part of the sale agreement.

A seller-financed sale doesn't usually involve a bank.
Buyer and seller agree to terms that suit themselves.

Agreement on Terms

Buyer and seller agree on the purchase price, down payment, interest rate, and repayment schedule. These terms are flexible and tailored to both parties' needs.

Legal Documentation

To make everything official, you'll draft a promissory note. This document outlines the details, including the repayment terms and any collateral involved. It's essential to have this paperwork to protect both parties.

Transfer of Ownership

The sale can close once the buyer and seller agree to the terms, sign the legal documents, and transfer down-payment funds. Then the buyer starts running the business, possibly with help from the seller.

Repayment

The buyer makes regular payments to the seller based on the terms set in the promissory note. These payments often include both principal and interest.

Examples of Terms and Conditions

• Down Payment: Typically, sellers require a down payment of 10% to 50% of the purchase price.
• Interest Rate: The interest rate might be comparable to or slightly higher than bank rates, reflecting the seller's risk.
• Repayment Period: The term for repayment can vary, but it's usually between 5 to 10 years.

Benefits of Owner Financing

Owner (seller) financing offers several advantages that can appeal to both buyers and sellers in a business sale. Here's how each party benefits:

Easier Access for Buyers

Traditional bank loans can be tough to get, especially for small businesses. Seller financing bypasses the bank, making buying a company easier even if you don't have perfect credit or extensive collateral.

Potential for a Faster Closing Process

The whole buying process can be significantly faster without the need to wait for bank approvals. It means you can take over the business and start making it your own much quicker.

Sellers Can Potentially Receive a Higher Selling Price

Because owner financing can make a business more attractive to buyers, sellers might find they can command a higher price. Buyers are often willing to pay a premium for the convenience and accessibility of seller financing.

These benefits create a win-win situation, easing the transition for both parties and paving the way for a smooth and successful transfer of business ownership.

Risks To the Owner

While seller financing can offer numerous benefits, it's important to be aware of the potential risks involved:

Buyer Default

One of the biggest concerns for sellers is that the buyer may fail to make the agreed payments. The default can leave the seller without the full payment for their business, potentially having the challenge of taking back control of the company.

Legal Complexities and Need for Robust Contracts

Owner financing requires detailed legal agreements. An accounting/legal team must meticulously plan and draft an agreement to protect both parties. Careful negotiation is needed to address all potential issues.

Mitigating Risks

Mitigating the risks associated with seller financing is essential for ensuring a smooth transaction. Here's how Zenally can help safeguard the seller's interests:

Thorough Credit Checks and Due Diligence

Before entering a seller financing agreement, conducting a comprehensive credit check on the potential buyer is a must. Zenally can analyze financial documents and review the buyer's creditworthiness to assess their ability to meet payment obligations.

Structuring the Deal to Protect the Seller

The deal will include safeguards like securing collateral, establishing a reserve account, or setting specific financial covenants. These measures help protect the seller if the buyer encounters financial difficulties.

Robust Contracts

Having clear and robust contracts is a must. Zenally CPAs, working with your legal professionals, can ensure that all financial terms are clearly defined and that stipulations are in place for handling potential defaults or disputes.

Regular Monitoring

The financing agreement should require buyer financial reporting. It allows Zenally to monitor the buyer's financial health and compliance with the financing terms.

This proactive approach allows for early detection of potential issues, giving the seller time to address them before they escalate.

By involving Zenally's expert CPAs in these key steps, both buyers and sellers can enhance the security and success of their seller financing arrangement.

The Role of Earnouts

Earnouts allow a business seller to receive future compensation if the business achieves certain financial goals.

How Earnouts Are Structured

An earnout agreement specifies that the seller will receive initial payment at closing, with additional payments made if the business achieves predetermined financial targets during a set period. These targets can be based on revenue, profits, or other key performance indicators.

The earn-out agreement will specify the earnout period, earn-out payments, and other earnout provisions.

Benefits of Earnouts

• Flexibility in Negotiation: Earnouts provide flexibility, allowing parties to negotiate a sale price that reflects both current value and potential future earnings. This can make a business more attractive to buyers who are cautious about overpaying.
• Alignment of Interests: They align the selling and buying parties' interests post-sale, as both benefit from the business's ongoing success. The seller remains indirectly invested in the business, often helping to ensure a smooth transition and sustained performance.

Earnout Risk

Earnouts require careful consideration and precise structuring to be effective and fair for both parties. By understanding their complexities and planning accordingly, sellers and buyers can make the most of these arrangements.

• Complexity in Measurement: Determining whether the new owner has met the earn-out target can be complex and contentious. Disagreements can arise over financial calculations or interpretations of the agreement. It's important to have well-defined earn-out metrics.
• Control Issues: The buyer might make decisions that achieve short-term earnout targets but could be detrimental to long-term business health. Sellers might feel that buyers deliberately undermine the business's potential.
• Mitigating Risks: Clear, detailed agreements crafted by experienced professionals can reduce risks. Zenally's CPAs can assist in defining clear metrics and terms that are measurable and achievable. They can also offer oversight during the earn-out period to ensure compliance with the financial targets and terms set out in the agreement.

Recap

Seller financing, including strategies like earnouts, is an innovative way to facilitate small business sales. With careful planning and expert advice, buyers and sellers can navigate these deals successfully, with outcomes that might not otherwise be achievable.

Accessibility

Owner financing makes it easier for buyers to acquire businesses when traditional funding is unavailable, widening the pool of potential buyers.

Flexibility

It's possible to negotiate more flexible terms that suit both buyer and seller, including payment schedules and interest rates. You can add a layer of customization that isn't typically available with traditional bank loans.

Speed

Transactions can close faster since lengthy bank approvals don't hold them up.

Potential for Higher Sale Price

Sellers might receive a higher overall price for their company due to the attractiveness of seller financing to buyers.

The Risks

A significant risk in seller financing is the buyer defaulting:

• by failing to make timely payments
• by depleting the company's reserves, leaving it cash-poor and less resilient to financial challenges.

Protecting both buyer and seller requires comprehensive legal agreements. You'll need thorough preparation and professional guidance.