You’ve gone through these steps with your prospective buyer. You’ve answered all the due diligence issues, gotten agreement on some thorny problems, and are ready to move to a close. Then the buyer says his lender won’t approve a loan for the full agreed purchase price.
The failure of the buyer to get the necessary financing is an all-too-common reason acquisitions don’t close. Financing is the buyer’s problem, right? Yes … until the buyer asks you for some seller financing.
Step 8. Seller Financing.
Estimates are that about 50% of all acquisitions of businesses with an enterprise value of less than $25,000,000 require some form of seller financing. The reason? It may be difficult to get bank financing for an acquisition of a business with relatively small annual revenues and relatively small asset values. The lending bank may be unwilling to lend the full purchase price based on the asset value or the cash flow. Possibly, your buyer (perhaps a group of employees in an employee buyout) is not creditworthy enough for the loan (which might make you re-think the sale to that buyer). In any case, if the bank won’t lend enough money on the purchase loan, you’ll either need additional equity, a third-party subordinated debt lender or other financier, or the seller will need to finance the shortfall.
Seller financing usually involves the seller “carrying” all or part of the purchase price through a promissory note with the company, so the company pays the note to the seller over a period of time. The note may be interest only, with a balloon payment at the maturity date. Or it may require amortized payments of interest and/or principal, depending on the circumstances. The note may have provisions for pre-payments or additional payments if certain revenue levels are met. The seller may retain a portion of the company stock subject to a mandatory purchase at some future date.
The seller will need to coordinate with any bank lender as to the relative priority and collateral of the seller carry-back financing. The seller financing note will almost certainly be subordinated to bank debt, which causes additional risk and may result in payment delay for the seller. Seller retention of an equity interest will likely disqualify the buyer from SBA loans.
Technical discussion aside, the seller needs to decide if they really want to take the risk of carrying the seller financing. The buyer’s bank has already said they won’t take that risk.
Carrying some financing may be the only way you can sell the business in a distressed situation. Or it may be the only way you can sell to a favored buyer (a family member, an employee group).
Make a realistic assessment of the risks, and take steps to contain them. Consider the buyer’s business and personal balance sheet. A personal guarantee, subordinated to senior bank debt, might not be worth much as a practical matter. And you don’t want to discover that the buyer has run the business poorly, can’t make the payments, and end up taking the business back in worse shape than you sold it.
Careful drafting of the purchase agreement and note provisions is critical. Perhaps more important is the seller having the trust and confidence in the buyer’s ability to operate the business.
With the seller financing component behind us, in the next part we will discuss managing the transition for a successful sale and ongoing business.
