In selling any asset, there are two factors that work together hand in hand to comprise ‘the deal’ – price and terms. The money you receive from the sale of your business and when you will receive it. In theory, you could have an infinitely high price for the business if you were to accept infinitely long payback periods and low interest rates, or you can have an all cash deal paid immediately, but at a much lower price.
What happens when you have a buyer who can pay only $1M including all the money he can raise from his commercial bank, yet the seller wants $1.5M? How do you strike a deal to make this happen? The answer is that the seller needs to finance the remaining $500K of the sale, in the form of a promissory note where the buyer makes payments to the seller over time. This is called seller carry-back financing.
It’s interesting to see where the actual behavioural ranges sit: as statistics on sales of SMBs over the last 1997-2012 period in the USA show:
- In only 40% of deals was the seller paid 100% of the price in cash on closure, with the seller providing some financing in the other 60%.
- The amount of financing provided ranged from 10% to 100%.
- The mix of deals with 20%, 30%, 40%, 50%, 60% and 70% paid in cash was fairly even. Very few had 0%, 10% or 80% or 90% cash.
- Most sellers financed their deals at 6% to 12% over the prevailing cost of a bank loan.
- Deals were typically financed over 4,5 or 10 years, but the range varied from 1 to 20 years.
- 100% cash deals were typically priced 20% lower than deals where the seller provided financing.
The significant part of this is that seller financing happens 60% of the time and where the seller finances part of the deal, the typical price achieved is 20% higher than 100% cash transactions. That’s a potentially huge premium to be earned in exchange for taking on more risk. The other points suggest that the deal structure itself is highly negotiable, with a range of interest rates, repayment periods and upfront payments. If it was easy to compute an ‘average’ deal it would probably carry a fixed interest rate of 5% above commercially available credit, be repaid over 5 years, and pay 50% of the price in cash. Note that interest rates have to comply with Usury laws.
It’s easy to think that the seller-financed deal gets a 20% price premium only because the buyer isn’t paying the full price with his own money and thus feels free to spend, but that’s not the whole picture: what the seller does, by agreeing to finance the deal over time, is to share in risk. By doing so, the seller signals that the deal is worth backing and that increases the confidence of the buyer who then is willing to pay the higher price. There is risk to the seller however: seller financing is often done because the buyer can’t afford the required commercial credit facility; typically because they have a poor credit history. This is why the terms of the deal are often 5+ years – it’s enough time for the buyer’s credit history to clear and for him to then be able to raise commercial finance to cover the outstanding amount, which is often structured as a balloon payment. Obviously there’s a risk that a person who isn’t credit-worthy to begin with stays that way and the deal falls apart, in which case the seller is probably left with only the cash portion they received upfront. The buyer may also run the business into the ground and be unable to make the remaining payments. Given the inherent risks in SMBs, the 20% price-premium achieved starts to sound low.
I noted earlier that sales dataset reflected sales up the end of last year. In early 2013 the USA gov’t passed updates to the Dodd-Frank act (which was a sweeping reform of their whole financial system introduced in 2010). Part of the act requires all residential mortgage loans, including seller carry-back financing, to be negotiated by licensed mortgage originators. In other words, offering these loans is treated as a financial service and is now regulated. Although some loopholes/exclusions remain, repayment periods, interest rates, due diligence on the credit-worthiness of the buyer, and more are all now stipulated by the act. How much the Dodd-Frank act will impact on seller-financing in the sales of SMBs (as opposed to mortgage-backed property sales) in the USA remains to be seen, but its popularity and premium suggest its certainly something you want to consider when buying or selling a business. While normal ranges apply, everything is ultimately negotiable and two parties with sufficient flexibility will always get a deal done.