15 Critical Mistakes to Avoid When Selling Your Business

This article was originally written by Matt for BizBuySell: https://www.bizbuysell.com/learning-center/article/finance-options-down-payments/ Perhaps you are amongst the growing number of individuals who are interested in being their own boss by starting a business, or better yet, buying an already established one. Buying a business may cost you more, on average, than starting one from scratch, but aside from any tangible assets, what you’re really buying is less risk, existing revenue/customers, and a significant shortcut. In this article, I’ll be covering some common types of financing buyers utilize when purchasing a business and how much money it typically takes. So how much money do you really need to buy a business? As often answers go in business, it depends. It is more the exception than the norm that a business is purchased outright with a simple and flat cash transaction. In a market where financing options are plentiful, few deals outside of smaller asset sales are all cash purchases. In larger private equity backed deals, cash transactions are more common. SBA Financing What is often considered the gold standard for financing the purchase of a business is an SBA 7(a) loan. These types of loans are popular because they usually have competitive interest rates, are spread on average over 10 years to allow lower payments, are backed by the U.S. Small Business Administration, and typically only require about 10-12% of the transaction price as a down payment. The caveats of SBA financing, as with anything involving compliance with the government, is that the application process can take a while, 2-3 months on average, and you can only have one at a time. Some SBA lenders may be able to process it in as little as 6-8 weeks. In that application process, the lender will want to see a business plan and ensure the buyer has the skill set, knowledge, and capability to continue operating the business successfully in a manner to support the loan payments. Other aspects that come into play with SBA financing: Lease - if a business is location dependent, they will likely require the buyer’s lease to be for the life of the loan. Landlords don’t always want to commit to a 10-year lease. If the majority or all of the commerce the business conducts is remote, and the business is easily relocatable, then the location may not be an issue at all. Taxes - the revenue/income of the business being acquired must have been well documented on previous year’s taxes, ideally for at least three years. If the seller did not accurately report income, it does not matter how profitable the business was on the profit and loss statements. SBA only cares about the taxes. An experienced broker should identify this before the business goes to market. Competition from other types of financing - if a business is desirable enough, and if a seller has options, not having to go through an SBA application process with an acquirer can be an attractive alternative for a seller, leaving SBA dependent buyers by the wayside. Being an SBA pre-approved buyer does not automatically put you in a top consideration or make you a desirable buyer, but it can help. Seller Financing A second commonly utilized type of financing is seller financing, also referred to as an installment sale. This is when the seller of the business acts as the lender to the buyer of the business, usually with a significant percent of cash put down at the time of close, and the rest paid over a predetermined amount of time with interest. A common amount of cash at close is about 70-80% of the total purchase price, but it can be whatever percent is agreed upon between a seller and a buyer. I have done transactions with as little as 30% of the transaction price being cash at close, but there is risk for a seller to consider when accepting a smaller percent, which is why a lower percent is not common. Typically, at a minimum, the business itself, and its tangible assets, act as the collateral to secure the buyer’s loan with the seller. If the buyer were to default on their obligation, the seller then has legal grounds to reclaim the business and its assets through court proceedings. Since online or service-based businesses typically have little to no tangible assets near the value of the amount loaned, a seller may require additional collateral, such as a buyer’s real estate, another business, or some other form of security. Seller financing can be an attractive option for both a buyer and a seller for several reasons. SBA Alternative - if a business does not qualify for an SBA loan, and the buyer does not have enough cash, but the seller is confident in the buyer, it can be a great alternative. Taxes - a seller can spread their tax burden over several years and keep the income in a lower bracket. Always consult your tax professional. Interest - a seller can offer a competitive interest rate to a buyer, compared to an SBA loan, and collect interest on the financed portion of the sale they would otherwise not receive in an all cash sale. Payment Efficiency - prior to closing the transaction, the buyer and seller agree to a set payment schedule and can thus plan their future income/expenses. As opposed to another type of financing structure with fluctuating payments that I’ll get into next. Earnout A third common financing structure is called an earnout. It is similar to seller financing only in the sense that there is usually a portion of the consideration in cash at the execution of the transaction, with the rest paid over time with agreed upon conditions. Commonly, it is a percent of revenue, not profit, since profits are more easily manipulated, and paid quarterly until either a balance is paid or a time period has expired. Since it is a percentage of the revenue and not a fixed amount, payments can vary widely or be nothing for certain periods. Earnouts can get very complex and are typically preferred more by the buyer than the seller, but a seller may have the motivation to require it as well. The amount of money a buyer may need in an earnout structure can also vary widely, and depends on the reason for the structure. There can be scenarios with little to nothing down for what may be considered a high-risk acquisition, or as much as 90%+ down when only mitigating risk for a specific scenario or loss of a customer. Here are common reasons, with oversimplified term solutions: Customer Concentration - if a business has a customer that makes up a significant amount of its revenue (say 15%+), there is an inherent risk for an acquirer to lose revenue if that customer leaves. The solution is to base a portion of the future consideration on whether that customer stays or goes. If the customer continues spending X amount with the business, payments continue at X amount. If the customer stops business or changes providers for any reason, then payments stop or are reduced by X amount. Lack of Historical Performance/Expected Future Performance - if a business is young, or just added a significant new offering, or doesn’t have enough history with a certain revenue stream, or is going through some kind of change that makes future revenue uncertain, an earnout makes sense. If a seller expects changes in progress to increase revenue and profitability post transaction, they may require a ‘bonus side’ earnout where they share in the business’s future success. Industry or Market Threats - perhaps a buyer really likes a pool cleaning business but heard pool cleaning robots will be replacing humans as early as next year. The seller doesn’t agree and thinks the robots are many many years away from replacing humans to clean pools. They agree to an earnout structure under the condition the buyer will be able to maintain X amount of customers with an average X amount price. If the acquirer cannot compete with the robots, and business drops, the remaining balance is forgiven after a certain period. Owner Dependency/Relationships - perhaps a buyer is highly interested in a business but is concerned the seller is too involved, has too many personal relationships with clients, and thus thinks the business is too dependent on the seller’s personal involvement. The buyer and seller can agree on a structure that keeps the seller involved during a one year transition period and should any of a specific list of clients leave after the sale but prior to a certain date, the total consideration is reduced by X amount. Additional Financing Options for Buying a Business Other types of financing sources can be a traditional bank loan, a home equity line of credit (HELOC), cashing out a retirement account, or simply borrowing from family/friends, amongst others. If a lack of cash is your main obstacle, SBA might be your first best option, but you may be competing with many other similarly qualified buyers. If you have a little more cash to work with than others, and depending on various factors of a business, seller financing or an earnout may be a more feasible option, if not an all cash purchase. The type, size, and terms of a business you can acquire can obviously vary widely. Here’s some examples: Example 1 - You may be able to find a cafe or coffee shop for $100K that earns the seller $60K/year, but the seller works 50 hours/week, which means you’d be working 50 hours/week, unless you identify a way to increase revenue enough to hire support, or pay yourself less. Few, if any, businesses of that size are SBA financeable. The sale would likely require all or mostly cash. A HELOC can be a good option for smaller deals, as the process is much simpler and the only collateral is the buyer’s real estate and not the business assets. Example 2 - You find an e-commerce business you love that’s earning the seller $300K/year that costs $1M, but it’s not SBA financeable because the seller’s business taxes were commingled with another business of theirs. Perhaps you have and are able to offer $600K cash at close and seller financing for the rest. Example 3 - You find a distressed/asset only sale of a pressure washing business that only costs $30K total. It includes the necessary equipment and a website, but there are no customer contracts, or employees, and the seller only worked part time and seasonally. It will then be on you to grow the amount of customers, perhaps invest additional money into advertising, and find a way to turn those assets into profit. Example 4 - You find a property management company that makes $500K/year, the asking is $2M, and it’s SBA pre-approved. You have $400K total in the bank and it's a potentially great fit with your background. You make a full price offer but don’t hear back until the seller has accepted an exclusive offer from someone else. You discover later that larger companies are acquiring property management companies like crazy and you were likely beat out by a simpler cash offer. Example 5 - Perhaps your goal is to find a business that requires the least amount of your time, makes the most money, and requires the smallest down payment. Well, get in line, that’s what everyone wants, and I don’t blame you. For a business to be absentee, or semi-absentee, it needs to make enough revenue to pay full-time management, and still have profit left over for the owner. There is a reason why those businesses cost the most and have the most competition between acquirers, they’re in demand. In conclusion, there are many ways to finance many kinds of businesses with various amounts of money. If I could share a summative bit of advice for a first time buyer, it would be to know the size and kind of business you’re looking for and what your financing options are, while at the same time being open-minded to the process, and sincere about your limitations and expectations. Always consult with your professional advisors, financial planner, tax professional, partner, etc., when weighing options for your business acquisition strategy.