Sell a Business for CASH???
How a seller is likely to be paid is an issue that comes up all the time when dealing with small business owners – but usually later than it should.
Business owners – particularly those that own Main Street businesses – simply believe that when they sell their business, they’re going to sashey on down to their local bank and deposit the check from the sale. It almost NEVER happens that way.
And if you’re a business broker, managing the seller’s expectations is a big part of what you should be doing. And this expectation – that the seller is going to walk away with a check for the entire transaction amount – is one of the most important and should be handled early on in your relationship with the seller.
Businesses rarely sell for all cash and when representing a seller, a business broker has to educate the client in this regard. In fact, most small business transactions involve some level of selling financing. There is often a gap between the purchase price and the amount of cash the buyer has and the amount a lender will lend. This gap is usually made up by the seller taking back some amount of financing. Lenders lend money that depositors have deposited into their institution. If you think about it, the depositors “lend” the lender – the “bank” – the depositors’ money. The bank entices the depositor to do so by paying interest on that money. So, when the lender lends money to a borrower, it is really lending money that it does not own; money that belongs to the depositors.
As such, lenders want security – they want to KNOW that, no matter what happens, they’ll get the money they’ve lent out back with interest. And they get that security from assets that are easily converted to cash.
To use a simple example, in many countries, when you buy a house, a lender will generally lend a certain percentage of the appraised value of the house. The lender will have someone who is thoroughly familiar with the local real estate market – an appraiser – provide a realistic estimate of value. The lender will lend perhaps, 80% of that value because the lender will be fairly certain that, should the borrower default, the lender will be able to sell the house – possibly quickly if offered at a discount – and recoup the money it lent to the borrower.
But what will a lender look to for security when considering lending for the purchase of a business?
If the business includes real estate (not something we recommend from the seller’s perspective), the lender might approach the transaction as it would a house purchase; but probably will significantly discount the appraisal for two reasons: 1) the demand for commercial real estate is not as great as the demand for residential real estate and, 2) when times get tough, everyone needs a place to live. People will walk away from a commercial property (or business) much sooner than they’ll walk away from their home. So, the lender might lend 50% of the value of the real estate and a deal might look like this:
- Purchase price of the business is $500,000.
- Buyer has $300,000 cash to put toward the purchase of the business.
- Value of the real estate is $250,000 (and is included in the purchase price).
- Lender will lend $125,000 (50% of the value of the real estate)
- We have a shortfall of $75,000.
In this example, the buyer will likely look to the seller to take back that amount and be paid over time to make the deal work. The business broker has GOT to make sure that the seller is aware that this may be the way a deal unfolds.
One way to make this enticing to the seller is to remind him or her that seller financing is always more expensive than conventional (bank) financing. If the bank is charging the borrower 6%, it would not be unusual for the seller to charge 8%.
What if There is No Real Estate?
Most businesses lease their place of business so what does a lender look to for security?
First, the lender will look to the personal assets of the buyer; their home or other real estate investments, stock or bond portfolios, antique car collections, art collections, etc. Second, they’ll look at the assets of the business being acquired.
In the case of the business’ assets, there are two primary types.
One is what we refer to as FF&E, or furniture, fixtures and equipment. This would include automotive equipment such as cars, trucks, heavy equipment and the like, stuff that the business uses in its everyday operations. Depending on the business being acquired, this would also include specialty equipment such as manufacturing machinery.
The other asset a lender might consider for security could be inventory. However, inventory is considered only in certain circumstances.
For example, lenders generally won’t consider the inventory of most retail businesses because the inventory turns over pretty quickly. This would be the case if you’re selling a liquor store or auto parts retailer. On the other hand, if you’re selling a boat dealership or equipment-rental company, a lender may very well look to that for security.
Mind the Gap
But the lender will likely want a professional to appraise whatever security that will be pledged and then discount the appraised amount to cover its costs if it has to take possession of and then resell the security. If the security is appraised for $200,000, the lender will lend an amount that it feels it could recoup quickly in the market place should the borrower default.
For the lender, the speed at which it can unload any security is a critical factor in determining how much it will lend against the collateral. As you might well imagine, no lender wants to own 5,000 wedding dresses or hundreds of high-end power boats no matter how cool they look!
A lender will lend an amount that they believe they can recoup in a quick resale. They want to recover what they lent as well as their costs to recover. That amount will almost certainly be substantially less than the value of the assets securing the loan.
Few buyers will be able – or even want – to pay cash. In such cases there will almost always be a gap between the total of the buyer’s cash plus the lender’s offer and the amount the buyer and seller agreed to as a purchase price. In most cases, the seller will have to help close the gap.
Our course, The “How-To” of Becoming a Business Broker”, teaches how to structure the financing of a business acquisition and how to handle any real estate the business is tied to.
Become a Professional Business Broker…
The Bottom Line
If you’re a business broker, the education of the seller in this regard is paramount. And the sooner that education is provided, the less likely any surprises will erupt when you present an offer that will almost certainly include some seller financing.
And if you’re a business owner reading this, please remember it when it comes time to sell. The chances of you helping the seller “close the gap” are fairly good.
Next week’s post will continue the financing theme and focus on using an “earn-out” provision in the acquisition agreement, a tactic that also could provide the seller with the highest value.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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