Today, banks pay greater attention to cash flows and debt to equity ratios. Before, it wasn’t uncommon to see equity ratios of 4:1 or 3:1; however, banks now require a bank debt to equity ratio of about 2:1, and some are even using a 1:1 ratio. Another ratio we see the banks using is cash flow to total debt service (including interest, principal, leases and earn outs) of 2:1. This means that the earnings before depreciation, interest and taxes, need to be twice the total cost of debt service.
In the past, it was traditional for the seller to finance 15 to 30% of the purchase price through a seller take back note. As a result of the changes in bank ratios, the traditional seller take back note is becoming less acceptable to many financial institutions and few companies are able to meet the new ratio demands.
In several of the transactions we have recently negotiated, the purchasers have provided more than 50% of the purchase price in unencumbered equity, with the seller taking back a note for the balance. This change is quite significant, and has had some other interesting positive effects for the seller, such as:
- A premium included in the purchase price, for as much as 15 to 25%, as compared to an all-cash transaction.
- The take back is secured against the assets of the business. If the business fails, the assets are more valuable to someone who is familiar with the operation and could liquidate in an orderly fashion, or to someone who would be willing to step back in and operate it with a view to perhaps selling it to someone else.
- The seller should realize a higher interest on the note from the buyer than would be earned on bonds or G.I.C.s.
- The purchaser providing a higher percentage of the purchase price with his/her own equity is more selective in what business they consider buying and the price they are willing to pay.
The seller is more aware and understanding of the cyclical nature of the business and can take this into consideration when structuring the financing, including considering payments over a longer period of time.
The buyer is also in a positive position. The seller has a greater interest in the ongoing success of the business, and will have a tendency to act in a supportive manner towards the purchaser during and after the completion of the transaction.
The purchaser, in fact, has a greater chance of being successful without the requirement of cash flows to pay such high interest and principal payments at difficult times. The purchaser will also find the banks more accommodating if they are searching only for a small loan for working capital.
The process of seller financing can be approached in a number of ways:
The Promissory Note, with interest and principal payments paid monthly. The note should be amortized over five to fifteen years, with an ideal seller allowing the financing to be completed over a ten-year period. Collateral in the form of a general security agreement, debenture, mortgage or chattel mortgage would only be subordinated to the company’s bank for an operating line of credit.
Issuance of shares, preferred, special or stated value can also assist in seller financing. Tax advantages may exist for both parties, depending on how the equity is held.
Royalty payments or management consulting agreements can be arranged to assist with the success of the business and the seller can realize payments based on a percentage of sales or a percentage of gross margin. Generally there is a floor and a ceiling placed on these types of payments.
Retention of assets and then leasing them to the purchaser is a form of seller financing that can provide a steady income stream and a sense of security for the seller. A seller of a small printing firm may retain ownership of the real estate or an important piece of equipment and then lease these assets to the purchaser.
Finding a buyer for a business is often easier than arranging financing to “close the deal.” Mergers and Acquisitions specialists focus their expertise on the financing of a transaction to ensure that the seller is receiving at least a fair market value for their business. The goal in negotiations is to instill the confidence in the purchaser that the value of the business warrants paying more than fair market value. A seller with a vested interested in the ongoing success of the business is a positive first step.