While interest rates are finally starting to come down, the cost of capital when it comes to acquiring a business remains relatively high (nearly double what it was in early 2022 before interest rates increased). Our firm continues to see a trend towards more seller financing options, which can be a viable path forward for owners who are looking to take advantage of the high cost of capital while maximizing the overall value of their businesses. Rather than relying solely on third-party lenders, seller financing options allow the buyer and seller to negotiate terms that are often outside of the parameters allowed by most lenders. This approach often provides the buyer with more flexible terms than traditional lender financing while allowing the seller to take advantage of the higher interest rates and tax advantages of delaying a majority of the transaction past the closing. While there are inherent risks, below are some best practices to consider with seller carry/notes, earn-outs, and stock/equity rolls.
Seller Carry/Note
Using a seller note, the seller is acting as a lender to the buyer and the business serves as collateral with repayment terms similar to bank loans of 5-10 years. Interest is charged on the outstanding balance and usually ranges from 5%-8%. For example, if a business is selling for $3M the buyer could bring 20% down or $600K at closing which creates a seller note of $2.4M. With an 8% interest rate and 10-year amortization (assuming a final balloon payment in 5 years), the monthly payments are approx. $29,000 per month and the additional interest earned alone is over $750K over this 5-year period. Thus creating a net payout to the seller of around $3.75M for the business. While this method is not without risks, the approach can work well if the owner does not need a large cash payment up front for retirement or to pay off business debt. Additional strategies could include “claw backs” or adjustable seller notes that are tied to the performance of the business which can help the seller and buyer shoulder the risk going forward.
Earn-Outs
An earn-out is a flexible type of seller financing that ties a portion of the purchase price to the future performance of the business. This option is usually warranted when there exists a tremendous growth potential in the business that is anticipated over the next few years. However, it’s crucial to properly define the terms of the earn-out to help avoid confusion and unrealistic expectations after closing. One common approach to help set realistic expectations is to calculate earn-out payments based on gross profits (defined as gross revenue or sales minus cost of goods sold). While calculating earn-out payments based on gross revenues or net profits (which can be defined as EBITDA) is an option, using gross profits helps to address possible future risk in the cost of goods/labor costs going forward but does not force the seller to depend on how well the buyer will run the business and control other business and/or personal expenses. Most earn-out agreements cover a 2-5 year period and require regular financial reporting along with accounting reviews. Earn-outs often have defined caps and floors as well to help ensure the new owner is not paying out when the business is not performing as expected. The reward for sellers is allowing them to participate in the future growth of the business while sharing the risk with the new owner.
Stock/Equity Roll
In this type of financing, the seller agrees to accept stock or equity in the business as part of the payment. This option is common when the seller retains a partial interest in the business, or the business is growing, and the seller wants to remain involved in its future success. Similar to an earn-out, this option can generate large dividends for the seller for years to come. This is especially true for larger strategic or industry buyers that can make this a reality for sellers who are willing to take on risk and do not need the cash upfront at the time of the sale. While most stock/equity rolls are for a minority ownership in the current or new entity, the seller can often have direct influence over the performance of the company going forward by staying involved in the daily operations. Our firm is currently working with seller whose equity roll with the acquiring company could net more over the next few years than the purchase price of the business at closing.
In summary, seller financing is a powerful tool for buyers looking to acquire a business with less reliance on traditional lenders. Each of these financing options has its benefits and potential risks, depending on the buyer’s financial situation and the recent performance of business. It’s essential to carefully evaluate the terms of any seller financing agreement, consult with financial and legal advisors, and ensure that the structure of the deal aligns with both parties’ long-term goals. The majority of our business comes from referrals, and we appreciate your continued trust in our firm.
Robert W. Amerine
President, CBI, M&AMI
