Printing Money May Not be One of the Options for Financing a Business Transfer, but There are Options Out There.
For small to medium-sized businesses, there are several types of funding sources for financing a business transfer.
Each type is governed by the same basic factors, such as; transaction size, asset base, type of company and cash flow.
When beginning this step of the business transfer, it is good to know that delays in the financial process can be avoided early if certain precautions are taken. So before discussing a buyer’s main funding options, there are some overall matters to consider or prepare.
- Buyers should make sure to check their own credit and clean up any outlying issues.
- Personal financial statements are also important to have totally complete and ready, crossing all the “T”s and dotting all the “I”s.
A top level view and take away points for each of the main funding options
All Cash Sale
Most sellers will, of course, be favorable to an all-cash offer. It is also a given that an all-cash offer can come with a steep discount. This discount is about 40% of that of a suitable offer with financing.
Another alternative to bank financing is owner financing. Not all transactions are acceptable for institutional financing, and if an owner is not willing to discount their asking price 35-40% for an ALL Cash Sale, then owner financing might be the only other option for financing a business transfer.
The Small Business Administration (SBA) is a federal agency that will guarantee a portion of an approved loan. Financially, they only consider the EBITDA and the adjusted EBITDA. They use a strict debt coverage ratio to ensure a borrower will be able to repay the loan, pay themselves a salary and have enough left over for emergencies. Along with cash flow, the SBA looks at the buyer’s industry experience as part of their approval process. A buyer should make sure that the bankers and intermediaries they are using are familiar with this process.
An earn out is a negotiating tool that can off-set the sales price and allow a portion to be paid at a later time with specified positive revenue within a specific time period. If profits decrease, then the earn out percentage decreases. However, if the profits are higher than projected as negotiated in the terms, the earn out does not increase. The reason the earn out will stay at the same amount is because the increase is considered the result of the buyer’s efforts. Therefore, it also justified the higher price the seller was asking. By keeping to their guns, in this scenario, this option works well for both sides.
This financing is against the assets in the business or personal assets to collateralize the loan. Financial institutions often heavily discount the value of the assets to protect the bank’s risk. These loans are a great option for lines of credit and real estate loans.
To learn more about funding and financing a business transfer, a copy of Entrance – A Guide to Buying a Business by Alex Vantarakis can be purchased in paperback form or as a download at The Vant Group – Book page.
Who is Your Buyer?
Before starting the selling process, determining where your potential buyer will come from will put you ahead of the game. Know who your buyer really is.
Each business transaction is different, but there are common factors to any deal. There are certain main aspects of a buyer, each with their own list of pros and cons to consider, which typically are:
- Do they have industry (whichever type your business falls under) knowledge/experience?
- Are they a first-time buyer?
- Will they need financing?
A business broker should be able to give a preliminary idea or priority list of the most likely types of buyers. By knowing the type of buyer, the seller will have a better understanding of their needs or constraints when it is time to make or close the deal.
Broken down to the main or top-level categories, there are essentially six (6) different types of buyers. Again, what is a “pro” for one type, might be a check in the “con” bucket of another type.
Is Your Buyer the:
A usual concern for this type of buyer is whether or not they are trying to relocate or stay in their current geographical location. These are often first-time buyers, but make sure they are serious. A business transfer requires a doer, not a dreamer who is not ready to leave their current state of employment.
Competitor or Vendor
This can be the best idea or the worst idea. Though they will have knowledge of the industry, if the business transfer is not a quick process, a competitor can cause harm in the marketplace to drive down the revenue. However, due diligence should be cut markedly. Depending on their motivation, they could pay a considerable amount more than asking or their situation might not require inventory that could be on hand and therefore result in not wanting to pay top dollar.
A great option for bank financing if they can come up with the funds for securing the loan. Being that they are already invested in the business, they are of lower risk. If they are not able to come up with these funds, owner financing should be expected to be on the table. So it is fundamental to know if the business is being sold to a business minded individual.
They are always looking for a good deal but are not interested in handling the day-to-day responsibilities. If a good management team or the owner is staying on in some capacity to run the business, the deal is more likely to sell for asking price.
Keeping a business in the family can be ideal. A good rule of thumb is to use an unbiased third-party company to handle the valuation before a deal is put on the table. Family transactions can carry the added weight of emotion, so using separate attorneys and CPAs as any other business transactions is recommended. Because of familiarity, it can also lengthen the time for an accepted offer. Make sure to set clear expectations so relations are not damaged in the process.
Foreign and Public Companies
This is a very unlikely buyer for small businesses. The larger the transaction, the more viable an option this buyer type becomes. Being in contact with this type of buyer will require clear mediation to determine what each other’s requirements of the deal really are.
To learn more about how to find the right buyer for your business, pick up a copy of EXIT– A Business Owners Guide to Selling a Company, by Alex Vantarakis.
Closed Deal Case Study: Unrealistic Expectations of Business Value
Challenge: Business owner neglect led to a significant revenue decline without understanding the impact on the business value
A business owner that sold home décor contacted The Vant Group (TVG) to sell their business. The business was over 10 years old and the owner was becoming distracted by other life ventures. Due to this, they started to lose interest in the business and revenues began to decline. Eventually, it dropped to 25% of previous revenue, and the decision was made that it was time to sell. The owner’s expectations of the business value were based on the profitability of the business when it was in its prime. Unfortunately, the value of the business was now significantly less than had it sold before the decline in revenue. After understanding their current value with a valuation of the business, they chose not to market the business for sale and hold on to it.
Approach: Value is set by what the buyer is willing to pay
A year later, TVG received an email from a buyer that was looking for a type of business with very specific criteria. The profile fit the home décor business and TVG contacted the owner of the business to ask if they would be interested in talking with this buyer. Unfortunately, they had allowed revenues and profits to decline even further during that year. The buyer put in a Letter of Intent and the seller countered. The buyer was not willing to pay what the counter offer proposed as the seller was still unrealistic about the current value of the business. Many months went by and finally, the buyer decided to give another offer. There were several months of back and forth on the offer. Eventually, the seller had decided to move from Texas to another state. The seller realized that they needed to sell the business before they moved. At this point, the seller became realistic about the offer they had received. Though they had not put their business up for sale and had let their business decline, fortunately, they contacted TVG and allowed this guidance to provide an offer through the TVG connections.
Result: Closed in one month after terms were agreed upon
The seller now needed a quick sale and realized that the deal terms and purchase price offered by the buyer were their best options. The buyer and seller settled on a final purchase price, terms of the sale which included a consulting agreement and future earnings, and which inventory items would be included in the purchase. Luckily, they were able to sell their business within a few weeks of selling their residential home in Texas and make a clean break to their new state destination. Without the help of TVG, they would have never sold their business, and it would have died a slow death. Now, their original designs and home décor items have been placed in willing and capable hands. They will also be able to see the business they founded gain back the level of recognition and profitability it had once known with the goal of even greater growth.
As a Business Owner – Salary, Draw or Both!
When looking at a balance sheet, there are a few ways an owner can receive compensation at the end of the day.
How to go about this should involve an accountant and an attorney who is on the payroll or ones that are entrusted to give sound advice.
Depending on the structure of the company, the owner might be limited to the ways they are able to bring in a personal income from the business. Uncle Sam has regulations in place for owner compensation which is different as a sole proprietor, to a partnership, or to being incorporated or an LLC.
One way for a business owner to be compensated is with a salary.
This method includes the owner to pay employee taxes and employer payroll taxes. However, if you are an S-Corp or C-Corp, you do not have a choice and must receive a regular salary. If you are an officer of an LLC, which most owners are, then this method also applies. The company’s legal and accounting team will be able to determine the limits which best suit the business so not to overtax the owner.
Regardless of the business type, a salary has other benefits that are not directly related to the money received. It is one way to separate personal and business finances. This keeps the red flags down so Uncle Sam is less likely to audit from irregular cash flow. It can also help to regulate smaller businesses and be a source to offset other expenses. Another benefit to taking a salary is when the time comes for a business transfer or taking out a business loan. Especially if the compensation is comparable to a position the owner is doing in place of hiring an employee, this will allow EBITDA calculations to be easily obtainable in this respect.
Another way for a business owner to be compensated is with an owner’s draw.
For sole proprietors and partnerships, this might be the only way they receive compensation in the beginning. When growing a business, it can be difficult to factor in a salary too. However, when taking an owner’s draw, regular payments are still a good idea for the same reason as with a salary. Unwarranted audits are hardly welcomed, especially if they are easily avoidable. A simple way to calculate a draw is to gather the common personal bills and business receivables that can also be logically documented. These can include shareholder distributions, auto expenses (insurance, gas, loan payment), insurance and medical payments, and cell phone bills to name a few.
What about both?
When taking a salary, additional compensation in the form of a draw is also possible.
The right calculation for each company will vary. There are tax implications for each way of handling how compensation is received. Taxes are owed on profits and revenues which is where the draw is coming from, and taxes are owed on salaries in the form of employee taxes and employer taxes. Bring in the company’s legal and accounting personnel to answer what these implications are as they will be the ones handling the questions once tax time comes around. Knowing the entrepreneur salary options is the first step, having a solid team of business advisers is the safest step.
For further reading that asks all of these questions and more is, The Entrepreneur Salary: How Much (and When) Do You Pay Yourself?
By David M. Wang, Esq.
Collective Insights on business ownership has David Wang posing the question to business owners, “Should I Give Employees Equity in the Business?” with added food for thought from our in-house attorney consultant.
Many business owners need to find ways to recruit and retain employees. The cost of training employees is high, and finding a great employee can be difficult and time-consuming. The reoccurring idea to solve this problem is handing out equity. In other words, giving them a participation in the upside as a way of recruiting and incentivizing employees to stay. However, giving employees a piece of the upside is the most complex way to give employees equity. There are many things to consider when making a determination to go this route.
Giving equity is a taxable transaction. You are giving an employee an asset of value.
It may not be cash, but the tax code treats it as income. Outright giving the equity to an employee means that the company will need to do a valuation to determine the value of that equity. That valuation has a cost. The employee will report that equity as income and have tax liability for the value of that equity. The employee will not see getting the equity as a positive experience unless you pay for that tax liability.
Many business owners ask about granting options.
Their friends that work for Texas Instruments and Frito Lay get stock options. Stock options work for a publicly traded company because the employee can sell the stock to convert their stock compensation to cash. This cash can go toward the purchase of a car and pay the taxes associated with getting the stock. The equity of privately held companies does not have a market, and you do not want employees selling your equity to just anyone that will buy it. This means that equity in a privately held company cannot be converted into cash. In fact, the equity in most privately held companies does not produce any cash until there is a sale of the company, which in many cases is a long time or never.
The most complex part of giving equity is how you get it back when the employee takes another job, is fired or laid off.
Most businesses do not want employees to be able to keep the equity after they stop working for the company. The concept is that the employee needs to be employed when the equity becomes cash. This means that you will need to have buy-sell terms that deal with the employee quitting, getting fired for cause, getting laid off, getting divorced, dying and becoming disabled. These terms will need to include what triggers the buy-sell terms (i.e. what is “cause” and what is “disabled”), how to determine the purchase price, payment terms of the purchase price, and other important terms. Then, the governing documents (i.e. company agreement for a limited liability company) need to take into account voting rights of the employee, manage participation, tax treatment and other complex issues.
As you can see, giving an employee equity is complex and must be documented with solid agreements. You cannot go with an “understanding.” Employees will remember the “understanding” the way they need to remember it. Getting all of this squared away could mean a few thousand dollars in legal fees and other professional fees, including valuations.
One way to look at equity is that the only people that should be equity holders should be people that are your true business partners.
True business partners, in this sense, means that they are people that can and will borrow from their 401K to make payroll. They are people who will not “go get a job” when the going gets tough. The investment that is required to take on and deal with a partner is significant and that person should be worth that investment.
So when asking, “Should I give employees equity in the business?” the decision should include a conversation with your attorney and CPA for why, how and which ones. You can also consider giving employees participation in the upside through bonuses and profit sharing plans. These alternatives are usually easier to structure, give you more control, and can require less in professional fees. These alternatives can be explored in future articles.
David M. Wang is a partner of Grable Martin Fulton, PLLC. He is a business attorney with over 21 years of experience. He can be reached at (214) 334-4755, or firstname.lastname@example.org.