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Business Sellers Increasingly Play Banker

Creative financing can help sellers command better prices or close a business sale. It can also create complications among banks, sellers, and buyers.

During the recession, the small business sales market was anything but active.
Sharp discounts of private small business valuations as much 30 percent to 40 percent reductions from 2007 levels are raising buyer interest.

But with sales on the table and the dialing for dollars, the bank loan market, which is still licking its wounds from the credit crunch, is coming up short. Buyers are increasingly turning to sellers to fill the funding gap. 

It's not that financing is unavailable. Businesses with strong recurring cash flow and significant collateral can still obtain debt. They're just raising less of it and at a higher cost. Buyers aiming to provide only 30 percent equity and funding 70 percent of a deal through a bank loan are now lucky to get a commitment for even 50 percent of the purchase price.

Increasingly, they are looking to the seller to supply a separate loan to cover the remaining 20 percent. The seller is becoming the lender of last resort. 

Seller participation in business sales is not new. Even in pre-recession times many business sales included some kind of vendor finance or earnout provision that delayed payment of a portion of the purchase price, up to 20 percent for one to three years.
Despite cutting down the immediate tab for the seller, vendor finance or earnouts continue to be used primarily as insurance against seller misrepresentations post-closing.

Commensurate with the additional risk, interest rates for seller loans are almost always higher than those for traditional loans.

Stay involved?

When much of the purchase price is tied up in vendor finance or earnouts, it's not uncommon for the seller to remain involved with the business for three to five years post-closing. Unlike a clean sale with residual involvement, the seller's realization of the purchase price is now tied to the buyer's ability to operate the company profitably. Bear in mind that vendor finance is unsecured, with limited transferability. 

When a deal goes south it can get messy fast. As the junior lender, the seller will take a back seat to the bank and will not have many remedies.

As a result, the seller has greater incentive to monitor the new owners and how they spend cash. This may involve seeking a position in the business so as to have a say in critical business decision making, including key management changes, new fundraising attempts, and large capital expenditures. It's fair to say that neither the buyer nor the seller may relish such continued participation. 

To avoid conflict down the road, it's best to keep paperwork in order, document the specific terms of the vendor finance in a separate credit agreement, and attach those terms to the purchase agreement.

Like a bank, the seller must evaluate the buyer's credit and consider carefully the buyer's ability to repay the loan. With higher bank loan margins today's funding costs are 5 percent to 7 percent higher than the terms of an equivalent loan just three years ago.

Fortunately, the seller is in the right shoes to make the call as to whether the buyer can manage the increased costs. After all, few will know the business better.