An Acquired Taste
This story appears in the October 2004 issue of Entrepreneur. Subscribe »
While negotiating the purchase of Anywear Shoe Co., a Seattle based manufacturer and distributor of professional footwear, Tim Johnstone had experience on his side. A former division manager for a large bank, he was on the due-diligence team that analyzed companies the bank wanted to buy-skills that proved invaluable when assessing his own acquisition prospect four years ago. In fact, his thorough analysis revealed some troubling facts about Anywear Shoe Co., including a wrongful termination claim by a former employee. "The value of the business to me was lower because there were so many uncertainties about how those issues would be resolved," says Johnstone.
So Johnstone, 52, took aggressive steps to protect his purchase. First, he asked the owner to finance 55 percent of the multimillion-dollar deal, insisting on a "holdback" that permitted him to deduct from the loan any undisclosed liabilities or claims against the company. The owner would also receive part of his payment in the form of an earn-out based on the company's performance. It was a grueling negotiation. The owner frequently changed his mind not only about the company's value, but also about providing financing. But the owner, who was having health problems, had to either accept the conditions or risk losing a viable buyer. "If we had not used seller financing," Johnstone says, "the deal probably wouldn't have come together."
It was successful planning on his part. A customer had filed a $120,000 lawsuit against the company, which Johnstone didn't learn of until the plaintiff called to settle two days before the court date. By then, Johnstone had also stumbled across some financial irregularities. The previous owner had no choice but to renegotiate the sales terms about 14 months into the deal. "There's always risk when buying a business. Having seller financing not only gives you additional comfort, but also some protections that you otherwise might not have," Johnstone maintains. "It turned out to be the smartest thing I ever did."
Putting Their Money Where Their Mouths Are
Sellers who provide financing send a strong message that the deal is on the up and up. On the whole, they're less likely to do anything to jeopardize the firm's success, such as starting a competing company. "They're selling something they created and that engages their ego at a deep level," says certified business appraiser Glen Cooper, president of Maine Business Brokers' Network in Portland, Maine. "Owing the seller money is a pretty valuable thing for a buyer to have."
There are other reasons to use seller financing. Foremost, motivated sellers often provide more lenient terms and a less rigorous credit review than a bank; unlike a conventional lender, they may take only the business's assets as collateral. Seller financing is also flexible: The parties involved can structure the deal however they want, negotiating a payback schedule and other terms to meet their needs.
Bear in mind that some sellers will resist, arguing that financing is more trouble than it's worth. But generally, the stronger their desire to sell, the more likely financing will be an option. "The first thing [sellers] say is 'I'm not carrying any paper.' That means they're going to turn away good deals," says consultant John Martinka, president of Business Resource Group in Kirkland, Washington. "They're reducing their market tremendously if they're not willing to carry the deal."
What's more, seller financing is often necessary for companies that banks don't understand, as well as those lacking tangible assets to serve as collateral. "Those situations may be suited to seller financing simply because the business could be a tough sell to a bank," observes Minneapolis attorney David Koehser.
Speed is also a determining factor. It can take months to negotiate a purchase, and the dealing parties often don't have the patience for a drawn-out funding process. On their own, they can usually reach a financing deal quickly, while a bank loan can take up to 120 days. "What if you spend 30 days looking at the business, another 60 days negotiating with the seller, and then it's subject to bank financing?" Cooper stresses. "Time is the enemy of every business deal."
The Devil's in the Details
In seller financing, the business and its related assets secure the loan. While a personal guarantee is generally required, sellers rarely file liens against a buyer's personal assets. The typical loan runs five to 10 years, with a steep initial cash payout, sometimes as much as two-thirds of the transaction. Many buyers must obtain a bank loan to meet the exorbitant down payment requirements. Banks generally view such transactions favorably because the seller shoulders some of the risk. Johnstone's bank had misgivings about helping him buy his company-which is now valued at close to $10 million-but the seller's willingness to fund half the deal helped allay concerns.
The buyer may also require a working capital loan to support business operations after the takeover. When a third-party lender is involved, though, tensions often flare over who gets paid first in the event of default. Says Koehser, "If you have to take out a line of credit, the bank is likely going to say 'We want a first priority security interest in all your business assets.' But the seller says 'I'm going to finance two-thirds of the purchase price on this deal, and I want a first priority security interest.' Early on, there should be discussions about how to involve the bank and satisfy the seller's need for security."
Seller's Remorse
Even if the financial deal goes off without a hitch, the seller may not just ride off into the sunset. In addition to expecting progress reports, the previous owner could visit regularly. "Maybe the seller misses the business," Koehser says. "If you add financing, then the seller says 'It's legitimate for me to come in and look over your shoulder, because it's my money that's involved.'"
It's also not unusual for the seller to restrict certain business activities, such as selling assets and acquiring additional companies, until the loan is repaid. One of Martinka's clients, for example, is contractually obligated to get the seller's approval for other business acquisitions or pay off 80 percent of the credit note. The seller may go so far as to dictate the buyer's salary and limit profit distributions. Nonetheless, the smaller the loan, the less control the seller has over the buyer. "The larger the percentage of down payment," Cooper says, "the more the buyer calls the shots."
For starters, owners who offer financing generally command a higher sale price. "Buyers are often focused on achieving a purchase on terms that allow them to buy with as little 'cash in' as possible, even if the long-run costs are higher," says certified business appraiser Glen Cooper, president of Maine Business Brokers' Network in Portland, Maine.
Sellers may also reap certain tax advantages by providing financing. Indeed, if owners are willing to finance at least part of the purchase price, they may be able to report capital gains from the business sale in installments, thus avoiding a heftier tax bill. "This stretches out the capital gains tax into future years," says Cooper.
The ability to collect interest that would otherwise go to a mainstream creditor, such as a bank, is yet another incentive for sellers to finance the buyout. Because a seller-backed loan normally carries an interest rate of 8 to 10 percent, owners can earn more than if their money was simply sitting in an interest-bearing account.
Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.
