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Owner Financing Pt.2: Benefits, Pitfalls and Setting Up Deals

Money and graphs

So how does owner financing help retain the support of the seller, and why would the buyer want to?

By tying the seller's receipt of the sale price to the ongoing success of the business, the buyer ensures that the vendor has a vested interest in helping out post-sale - passing on all relevant knowledge and expertise, advising on strategy, and introducing the new owner to relevant clients and suppliers.

"We stay in touch with the vendor and seek their advice," says Roland Stringer, who recently part financed the purchase of a dating agency with promissory notes. "With so many business deals, the deal gets done and you never see or hear of the vendor again."

Owner financing is therefore, as Richard May of business brokerage TSL Business Sales points out, obviously invaluable "where the purchaser is perhaps concerned that the outgoing owner's involvement in the business is quite high."

A good example of such a business is a marketing agency, where the previous owner's charisma, expertise and reputation are pivotal factors in attracting and keeping clients. If they sever all ties upon sale completion, an exodus of clients could ensue.

Other businesses where the buyer might want the seller to help out for a while are those which have developed esoteric systems, such as certain hi-tech businesses.

Any staff still in situ after the transition will be able to help any new owner of course. But retaining the former proprietor on a consultative basis might be vital for understanding the company's modus operandi, how it has developed and how it should continue to develop if the company is to thrive.

One broker who specialises in selling businesses can vouch from his clients' experiences that owner financing is an effective way of retaining the seller's support.

"I have a client buying a business with a down payment, and the rest is on a monthly basis over five years. He was six months into the deal and some of the customers were not paying quick enough.

"The buyer then contacted the seller and asked him what he should do. So the seller made a couple of phone calls to the customers and bingo, it was all OK again.

"So from a buyer's perspective, it is a benefit as the seller is morally locked in, and has a selfish interest to make it work over 'X' number of years."

It is worth noting that you don't have to offer loan notes to secure the cooperation of the current owner post-sale; you can stipulate in the asset or goodwill purchase agreement, or share purchase agreement, that the seller has to stay on in a consultancy role for a given period. This at least means you can define specifically the scope of his role, although you could argue that the seller will be especially helpful and supportive when his destiny, like the buyer's, is tied to the fortunes of the business.

So given that the seller has a vested interest in the business's success, does that mean that a commitment to owner financing represents a vote of confidence in the company?

"It lends a tremendous amount of credibility to the transaction," says Tony Calvacca of New York Business Brokerage. "The buyer is going to be comfortable knowing that the seller has confidence that the business is going to be income producing and the buyer is going to be capable of repaying those notes.

"The buyers feel much more comfortable when the seller is holding at least something.

"Seller financing simply makes the deal easier to do."

One could also argue that agreeing to take a loan note is a ringing endorsement of the buyer as well as the business. Like a bank, the seller will only want to lend the money to a buyer with the right credentials.

The successful sale of a business is contingent on the two parties trusting one another. Any doubts about the other party's sincerity will jeopardise the deal.

A seller might claim to be retiring or seeking a fresh challenge - but what if there's another reason for selling?

What if they're seeing insidious developments in the business that due diligence (essentially like an MOT) might miss? What if, unbeknownst to anyone but perceptive industry insiders, market conditions are set to become hostile?

Acceptance of loan notes can assuage mistrust of a seller's reasons for selling as it means that both buyer and seller have a stake in the business's success. If the business flounders and the buyer defaults on repayment it leaves the vendor back at square one: owning a business he no longer wants.

So the vendor shoulders much of the risk?

"The biggest downside" for the seller, says Tony Calvacca of New York Business Brokerage, "is the financial risks of the buyer failing at the business and failing to pay the notes."

The spectre of going full circle looms over seller-financed deals.
"There's personal disruption in a seller's life if they need to go back and rehabilitate the business, especially if they've moved out of state. It can take a long time to remarket and resell it."

Another, obvious drawback is that the seller doesn't get all of his or her money upfront.

So if the seller needs all the cash up front to buy another business straightaway, is owner financing simply not an option?

There is a way to circumvent the delay in getting your money - but it comes at a price.

"There are companies out there - we've been prospected by quite a few - that purchase seller's notes," explains Calvacca. "We have a deal right now where the seller wants his money now and wants us to find a buyer for his notes.

"It's an expensive proposition, but for someone who wants to get their hands on a chunk of cash to make an aggressive acquisition it may make sense to do that."

How does the vendor benefit from owner financing?

"In some cases it could result in a better offer," explains Calvacca. "It makes it easier to attract more and better buyers to the deal."

Prospective buyers will be more confident that the business is a good one, and therefore be willing to pay more. And, particularly in the current climate, it brings in buyers who might otherwise have struggled to raise the capital.

The money the seller receives is boosted by more than just an inflated price, however.

For a start, there's the interest on the loan. For example, if they agree to a carry-back note at 8% over nine years on a $200k business, the seller will ultimately receive $400k and double their money.

"And there are tax advantages," says Calvacca, "because the seller is not taking one lump sum payment. They're going to leverage that for tax purposes by taking payments over a longer period of time."

If owner financing increases the chances of a sale in ordinary times, then the present extraordinary circumstances, where banks are withholding credit from all but the most watertight business proposals, can amplify this benefit.
"In the current climate," says May, "a seller is rather more likely to get a sale out of it."

Who tends to suggest owner financing - the buyer or the vendor?

"Typically, the broker and/or the seller themselves will, if they're knowledgeable, structure the terms prior to marketing the business," explains Calvacca, "because if terms are left to be discussed, and there's ambiguity when it's marketed, then you'll get far fewer responses. If the terms are attractive and spelt out clearly in the marketing materials, it will dramatically increase the response that you get."

Buyers and their advisors also need to be proactive in evaluating their options for financing deals.

"The buyer will predicate their interest on how it's positioned for financing, so we as brokers make it part of our core services to help them look at all available financing.

"Frequently we, and many quality brokers, get a form of pre-qualification, finding beforehand what possible terms would be available so we can outline those to buyers."

With credit channels still running dry, are brokers recommending owner financing more readily?

"Brokers are starting to broach that topic earlier on with sellers," observes Calvacca, who thinks the current austere climate means brokers have an extra responsibility to manage their clients' expectations.

"When sellers tell brokers they want all cash for their business, if a broker points out a realistic expectation early on that they shouldn't expect to get all cash, it makes it easier down the road.

"Sometimes you'll have inexperienced, or less than candid, brokers who'll suggest that they can achieve an all-cash deal, which ingratiates them and helps them get the assignment. But in fact, that works against them down the road when they can't deliver on it."

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