The Pro’s and Con’s of Providing Buyer Financing for Your Business.
by Bruce Tannas
If you are like many small business owners, your business represents your largest investment of time and money. The sale of your business also likely represents the potential to reap the rewards of the investment in your business so you can move on to a new opportunity or retire. So, it is not surprising that you might be hesitant to provide any financing to a potential buyer of your business. But for many potential buyers of your business having some vendor financing may be the only way they can purchase your business.
Background on Financing a Business Sale:
As you consider all the aspects of selling your business, you will also need understand how most purchases of a business are financed. Very few businesses are sold as a cash sale where the buyer has cash in hand to purchase a business, so some form of financing is needed to complete the sale. The typical sale of business will include financing from multiple parties including the buyer (which may include money from the buyer’s family), bank loans and/or developmental bank loans (e.g., Community Futures, Business Development Bank – BDC, etc.), and some seller financing.
Most banks will use the Canadian Small Business Financing Program (CSBFP) to finance the lion share of the purchase of the business. This program is a guarantee program, like the Canada Mortgage and Housing guarantee, that the Government of Canada offers the banks in order encourage them to finance small businesses. Loans, made through the program, can finance the purchase or improvement of land or buildings used for commercial purposes, the purchase or improvement of new or used equipment, and the purchase of new or existing leasehold improvements (e.g., renovations to a leased property by a tenant). While this government program, which is accessed through the mainstream banks, can finance a significant portion of the purchase it does not cover everything. It will not cover financing items such as goodwill, working capital, inventories, franchise fees, or assets that a holding company acquires. Those items must be covered by other means such as buyer investment, developmental lenders, alternative lenders, and vendor financing.
Financing working capital and inventories is possible through the banks or developmental lenders as well. Depending on the strength of the client and the business cash flow the banks and/or developmental lenders will provide finance a portion of the inventory to be purchased. In addition, the purchaser may be able to finance some working capital using a line of credit or up-front term loan either through a traditional bank or developmental lender. Having said that, there will be an expectation that a higher percentage of working capital amounts will come from the buyer.
Financing goodwill (the value of your company’s brand and market position) is much more difficult, though possible, to finance. Because there is no tangible asset associated and it is often hard to determine the true value of goodwill, so most banks and developmental lenders are reluctant to lend for goodwill. So, this is where vendor financing often comes in to complete the financing of a sale.
For example, if a business is sold for $90,000 with $50,000 of equipment and fixtures, $25,000 of inventory, and $15,000 goodwill, and needs $10,000 of working capital; the financing might look like this chart:
|To be financed||Buyer||Lender||Seller Financed|
|Equipment, leasehold improvements & Fixtures||$10,000 (20%)||$40,000 (80% through CSBFP)||$0|
|Inventory||$7,500 (30%)||$17,500 (70% through a bank or developmental lender)||$0|
|Goodwill||$3,000 (20%)||$0||$12,000 (80%)|
|Initial Working Capital||$3,000 (30%)||$7,000 (70% through a bank or developmental lender)||$0|
|Total Financed:||$23,500 (23.5%)||$64,500 (64.5%)||$12,000 (12%)|
As in the example, banks and developmental lenders won’t finance 100 percent of anything and the typical percentage ranges from 40-80 percent depending on what is being financed and the industry the business is in. Hard assets such as equipment and fixtures are usually financed at a higher percentage than inventory or working capital. Goodwill, if it is financed at all, will be financed at a much lower percentage. The gap between what is financed and what is not financed by lenders must be made up by the purchaser and potentially you as the seller in the form of a vendor loan (sometimes called vendor take back financing).
Pro’s and Con’s of Financing the Purchase of Your Business:
- Lowers the amount of upfront investment needed by the buyer thus allowing more potential buyers to consider purchasing your business.
- Vendor financing of the goodwill allows the seller to potentially get a higher price for the business.
- Receive regular income over the life of the financing agreement.
- Additional revenue on the sale of your business from the loan interest.
- Some of the cash in the purchase price is deferred until the buyer can pay back to the amount financed by you.
- Potentially higher cost for legal fees on the seller’s part (you can negotiate that the buyer pay these fees).
- Potential risk of not getting repaid some or all of the vendor loan if the business fails or is unable to make the payments.
Tips on Structuring Vendor Take Back Financing
If you are planning to offer vendor financing, you should contact your lawyer to discuss how best to structure the deal and protect yourself. With that in mind, here are some tips on structuring vendor financing.
1) Set a Limit on the amount of Financing Your Willing to Provide:
Unless you want to be in the financing business you should set a maximum amount that you are willing to finance. You don’t have to tell anyone what that amount is, but you should have a sense of the amount that you are willing finance in order to close a deal. If you’re wondering where to start, think about getting cash from the sale on hard assets and inventory while financing some or all of the goodwill. As stated earlier, goodwill is hard to finance and for you it represents your profit on the sale of the business.
2) Vet Potential Buyers Early About Their Financing Plans:
Find out early if the buyer has thought how they will finance the purchase and if they have any money of their own to put into buying it (at least 20-30 percent of the purchase price). If they can’t provide a suitable answer then move on from the buyer.
3) Realize that You Likely Are Not the Only Lender:
Chances are that the buyer will need another lender(s) to complete the deal. That is not a bad thing as the other lender(s) will complete a lot of due diligence on the purchaser (including credit and background checks) before offering financing. This allows you to offer financing with some measure of confidence that the purchaser has been properly vetted. However, if there is other lender(s), they will insist on being paid first and having first charge on the collateral. That means that you will have to be more patient on getting paid back your money and you will stand behind them if the purchaser defaults on loans.
4) Think of Financing as a Separate Deal:
The agreed sale price of business is one deal. Then the amount financed, the amount of time to finance the outstanding amount, the collateral, and interest on the financing is a separate deal to be negotiated.
5) Have A Proper Loan Document and Register Your Collateral:
Make sure that you seek a lawyer to ensure you have proper loan documentation and registration of any collateral you take to secure the loan. If you don’t then other creditors will potentially stand ahead of you if there is a default.
While offering seller financing can seem daunting, if you believe in your business and do your homework to vet the buyer, it can be a positive for both you and the buyer. It allows you to expand the field of potential buyers and negotiate a higher price while for the buyer it allows them to get a better business for their investment and let the business pay for itself through the cash flow of the business.
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