Consider financing options when selling company
While seller likely would prefer cash, other options can fill gaps in funding
Ed KirkNovember 7th, 2013
A 2013 study by the National Institute on Retirement Security found that Americans of all ages are "falling well short of the savings amount they need to secure their retirement." Roughly one-third of baby boomers have no retirement savings and another one-third have saved less than one year's salary. In total, Americans have set aside $14 trillion less than the amount they need for a comfortable retirement.
The situation is even more challenging for business owners who are nearing retirement. Not only has the recession made it difficult for business owners to save, but it also has forced many owners to use personal funds to keep their companies running. At the same time, reduced revenues or profits during the downturn have made many privately held companies less valuable.
Consequently, many owners who were counting on the value of their companies to fund their retirement have been forced to delay their plans. According to the Wall Street Journal, more than half of small business owners indicate their retirement is closely tied to their company; 38 percent of business owners already have delayed retirement.
Thankfully, the outlook is improving for thousands of business owners across Washington state who are nearing retirement. As the economy slowly recovers, many owners are waiting for the ideal time to sell or otherwise transition ownership. With so much riding on the business transition, the importance of transaction financing can't be overstated.
The nature of a transaction will have a significant impact on the manner in which it is financed. Transitioning the company to family members or employees, for example, would likely be financed differently from a third party sale. Corporate buyers, private equity firms, and individual buyers have access to a host of financing options, including stored cash, traditional bank debt, SBA loans, mezzanine financing, seller notes, and performance payments, among others. Most transactions involve financing from a combination of these sources.
Cash. Most business owners hope to be cashed out substantially when they transition their companies, particularly when selling to a third party. Assuming the sale process is well run, many business owners can be paid substantially in cash at closing. However, sellers should recognize even if they receive all cash, the buyer is likely to use one or more forms of debt to fund the purchase. A thousand of the largest U.S. companies were sitting on more than $981 billion in cash as of last July; that's up 61percent over the last five years, according to the Wall Street Journal. But even corporate buyers will often use debt to fund acquisitions in order to increase their return on invested capital.
Traditional bank debt. Many banks compete for relationships with small businesses. The banks provide a host of services, including credit lines and expansion financing to companies with whom they have deposit relationships and operating histories. Unfortunately, traditional bank debt falls significantly short of the financing required for most business transactions for at least two reasons.
First, the company's historical loans often were guaranteed by the personal assets of the owner. As the historic owner exits the company and a new owner enters, loans are more difficult to come by. The general risk associated with a transition, the lack of history with the new owner, and sometimes the new owner's unwillingness to provide a personal guarantee all can become obstacles.
Perhaps more importantly, traditional bank debt usually is collateralized by assets inside the company. But most profitable companies are far more valuable than the hard assets they own; the gap between the value of the assets and the market value of the company can be significant. Business banks don't like this gap, which they refer to as an "air ball" and which they typically won't finance in the absence of other collateral.
Mezzanine debt. One way to fill the gap between traditional bank debt and the market value of a company is through mezzanine or subordinated debt. Although some banks provide subordinated debt, it more commonly is obtained from specialized lenders who have raised funds specifically for this purpose.
By definition, subordinated debt is largely or entirely unsecured; there are no collateral assets to secure the loan. As a result, a mezzanine lender has limited recourse in the event of default. In exchange for taking on this higher level of lending risk, mezzanine lenders expect a higher reward, which they obtain by making the debt more expensive.
Mezzanine lenders often will charge much higher interest rates for subordinated debt. Additionally, they often demand payable in kind interest, which is converted to additional principal, and some form of company ownership in the form of equity or convertible warrants. Despite its higher costs, mezzanine debt can be a great solution in the right circumstances; the key is ensuring the company has sufficient cash flow to bear the additional debt load.
SBA Loans. For companies that sell for less than about $6 million, a great financing option is the 7(a) Guaranty program from the Small Business Administration. The SBA Guaranty program guarantees up to 75 percent of the loan, thereby significantly reducing the risk to lenders and encouraging them to make loans.
Under the SBA program, the loan is underwritten primarily on the basis of the company's ability to service the debt; as a result, the loan size isn't limited by the value of collateral assets in the company. The SBA last year approved 44,000 loans totaling more than $1.5 billion, so this financing mechanism clearly is popular. However, SBA 7(a) loans are limited to $5 million, and there are additional restrictions on the net worth of the borrower. Consequently, this type of financing is only available on relatively smaller transactions.
Seller financing. Buyers, banks, mezzanine lenders, and SBA lenders all like to see seller participation in transaction financing. The logic is simple: a seller who has some "skin in the game" has more incentive to ensure the buyer is successful following a sale. Moreover, seller financing often can close the gap between the value of the company and the financing available from other sources.
On the other hand, participating in the financing is contrary to most sellers' goals. Additionally, once a transaction is closed, a seller—even one who provides some financing has little, if any control on the strategic direction or financial success of the company. And like mezzanine financing, seller notes typically are unsecured, so a seller has limited recourse in the event a buyer defaults on the loan. For all these reasons, seller financing is a tricky topic; sellers should approach it very carefully and in the context of other key issues such as price, tax treatment, and experience of the buyer.
Performance payments. Occasionally, an ownership transition occurs while the company is in the early-to-middle stages of realizing significant growth. Agreeing on value is challenging in these cases, because sellers want to get credit on future potential, while buyers don't want to overpay based on current performance.
The solution, in some cases, can be found in performance payments. Under this structure, the seller receives additional amounts if the company achieves certain financial metrics post-transaction. In this manner, the seller is able to realize some benefits from the company's future growth, but the buyer doesn't have to pay for potential that isn't realized.
Performance payments aren't applicable for every situation, but they can be a key piece of the financing puzzle under the right circumstances. The key to making this structure work is establishing the right performance metrics, payout amounts, and payment timing.
Every transaction is different; the type and amounts of financing used will depend on the size of the deal, the nature of the transaction, the type of buyer, and the objectives of the seller, among other factors. Thankfully, there always is demand for strong companies. Even so, business owners need to establish clear objectives and run the transaction process in a manner designed to achieve those objectives. Additionally, owners can benefit substantially by engaging a professional team that knows transactions, understands financing, and can help find the right buyer.