Financial Components

Next, I’ll describe the financial components of the transaction structure in more depth and how they affect your overall deal structure, as well as the norms across transactions. 

Cash

Cash is king. Sellers always prefer cash, but buyers generally only put down as much cash as is required to motivate you to accept their offer. In most cases, the buyer will put down 60% to 80%, and the remainder will consist of an earnout, seller note, and holdback.

Can I sell my business for all cash?

The short answer is “Yes.” That’s the long answer, too, but the chances of selling your business decrease, and the timeline for selling your business increases if you demand all cash. While most businesses go to market without a price, asking for all-cash offers can significantly decrease the chances of selling your company. Buyers almost always consider multiple options when buying a business, and pigeon-holing them into all cash can make them hesitant. 

Debt and Liabilities

It’s essential to understand what happens to long-term debt when you sell your business. In some instances, the debt is absorbed in the transaction as part of the sale. But this isn’t the case most of the time. 

Short-term debt, which is a component of working capital, is usually included in the purchase price and is therefore assumed by the buyer. Short-term debt consists of accrued payroll and other ongoing obligations, such as rent, and payments to suppliers and vendors. 

The assumption of long-term debt is almost always excluded from the purchase price. There are three options for handling long-term debt at the closing:

1. You could settle the debt at closing through an escrow account. This is the most common method.
2. You can pay off the debt before the closing.
3. The buyer could assume the debt.

In most transactions, long-term debt isn’t assumed and is paid out of the proceeds at closing through an escrow account.

Seller Financing

How does seller financing work? If a business sells for $10 million and the seller carries a note for 20%, the buyer would put down $8 million and make payments on the remainder until the note is paid in full. Most M&A transactions in the middle market include s0me component of seller financing, though the amounts are low, often 10% to 20% of the transaction size. Seller notes are also commonly used in conjunction with third-party financing.

Advantages of a Seller Note:

• Lower taxes since you don’t pay taxes until you receive the money. But be sure the note is structured so it’s non-negotiable. 
• Less stringent requirements are needed for the buyer than obtaining a bank loan, which reduces the risk of a financing contingency if no third-party financing is involved.
• Minimal closing costs.
• Quicker closing time. 

A seller note is also commonly used in lieu of a holdback. One advantage of a seller note for buyers is the ability to offset the note against indemnity claims, otherwise known as a “right of offset.” Structuring a portion of the purchase price as a seller note can be used when the buyer is concerned about the veracity of your reps and warranties in the purchase agreement. The seller note would then have a right of offset based on the purchase agreement’s indemnification language. This right gives the buyer the ability to deduct amounts due under the promissory note for any indemnification claims. The seller could then argue that a holdback is not needed due to the right of offset in the seller note. 

The parties can also include negative covenants in the note, though this is rarely seen. Negative covenants reduce the payments if the business performs poorly, but also make the note appear more like an earnout, and most sellers won’t look favorably on this structure since the payments are essentially contingent. 

Nearly 85% of small business purchases involve seller financing.

How To Protect Yourself From Buyer Default

Because you’re functioning as a bank, you should pre-qualify the buyer before committing to financing a portion of the sale. A strong promissory note should be drafted with clauses that directly address either late payments or non-payments. A Uniform Commercial Code (UCC) lien should also be filed against the assets of the business to prevent the buyer from selling the business or its assets during the term of the note. 

You should also select a buyer you think will succeed from an operational standpoint. Additionally, you can require the buyer to maintain specific financial benchmarks post-closing, such as maintaining a minimum inventory level and working capital or specific debt-to-equity ratios. I also recommend that you have access to monthly or quarterly financial statements. This should enable you to spot problems early on, before they spiral out of control.

You can also obtain a buyer’s financial statements to ensure they have sufficient liquidity and are profitable, and research their previous acquisitions. Talking to the owners of companies they’ve acquired in the past may also be helpful. Depending on the size of the business, it may be prudent to perform due diligence on the principals of the company that wants to acquire your business.

Most problems related to seller financing originate from the seller accepting a low down payment. Otherwise, I see few problems regarding seller financing. Here are some common questions regarding seller financing: 

What interest rate is fair to charge?

In recent years, the interest rate charged on most promissory notes has ranged from 5% to 8%. The interest rate being charged depends more on the amount of risk involved than on the current cost of money. 

Some buyers argue that current interest rates are much lower and that the rate should be competitive with these. I explain to these buyers that such a loan is risky for the seller and that little collateral is available other than the undervalued assets of the business. If you default on a real estate loan, the bank can repossess the real estate used to collateralize the loan. But, if you default on a loan used to buy a business, there often isn’t anything to take back other than a struggling company.

Other factors that should be considered in determining the interest rate to charge include the total purchase price, the buyer’s level of experience and reputation in the industry, the buyer’s financial position, and perhaps most important, the amount of the down payment. The lower the down payment, the higher the interest rate that can often be justified.

What’s a third-party loan processor?

If you choose to finance the sale of your business, I recommend using a third party to service the loan. An experienced third-party loan processor can handle all aspects of collecting, crediting, and disbursing third-party payments. They simplify the day-to-day management and collection process as well as record-keeping – all of which frees up your time for more important tasks. An often-overlooked benefit of a third-party loan processor is that they serve as a buffer between you and the buyer if payments arrive late. That buffer can be extremely important in maintaining a good working relationship with the buyer post-closing. 

Can you sell the note for cash?

Yes, you can often sell the note after it’s matured for 6 to 12 months. There are many investors who purchase these notes, which effectively cashes you out. Unfortunately, investors will want to buy them at a steep discount from face value. If you’d like to leave this option open, it’s important to ensure that the note can be transferred or assigned to a third party.

Should you hire a private investigator?

If you’re considering financing a significant portion of the purchase price and doubt the buyer’s credibility, you should protect yourself. Money spent on an investigation could save you countless heartaches down the line if you find out the hard way that your prospective buyer is a bad credit risk.

A private investigator can reveal information about those who want to purchase your business. This information can help you determine the character of your buyer’s past and their creditworthiness.

It’s important to note that a signed release may be required by law to obtain this information. The buyer has a right to refuse the release, although they should understand your need to protect yourself if they ask you to finance the loan. Explain to the potential buyer that it’s a necessary action considering the financial risk you’re taking. They would have to do the same thing with a bank or financial institution. For more advice on this, consult your attorney. 

What documents need to be drafted?

You’ll need a promissory note and security agreement that address the key terms of the seller note. A Uniform Commercial Code lien on the assets of the business should also be filed post-closing. 

How many years should the note be for? 

Most notes range from two to five years. Common sense is the rule of thumb here. The cash flow from the business should more than cover the debt service (i.e., debt coverage ratio). Note that the term has a larger impact on the amount of the payment than the interest rate. If the cash flow is inconsistent, you should build in some cushion and structure the note so the payment is lower. This generally isn’t a problem unless the seller note constitutes a significant portion of the purchase price.

Third-Party Financing

By my estimate, third-party financing is involved in over half of mid-sized transactions. The buyer usually arranges the financing behind the scenes, so they don’t require any assistance from you in obtaining it. The one aspect of third-party financing that you may need to be aware of is the extent to which lenders include covenants in their loan agreement with the buyer. The lender must approve the terms of the transaction, and there are times when the buyer may need to propose new deal terms due to a lender’s requests. Knowing when this is a legitimate request vs. knowing when this is a ruse to renegotiate the terms is critical to protecting your interests.

Stock/Equity

Granting equity is most appropriate if you’ll remain in the business long-term and retain some level of involvement in the business moving forward. Technically, equity isn’t granted but instead is rolled over. For example, the buyer may only purchase 80% of your shares, so you retain a 20% interest. 

Long-term earnouts of five years or more should usually be replaced with equity. The primary advantage of equity as an alternative to earnouts is that equity often does a better job of aligning incentives and is also more suitable as a long-term strategy. Equity incentivizes you to think both short-term since profits can be taken out as distributions, and long-term due to growth in the value of the business over time. But both parties should also consider how you, as the seller, will eventually liquidate your ownership interest in the business. In most cases, this will happen through another exit in the future, which is the most common liquidity event. It’s also paramount that the parties draft bylaws, a shareholders’ agreement, and a buy/sell agreement to protect their interests and serve as a mechanism for resolving any potential disputes. 

Granting equity is most appropriate if you’ll remain in the business long-term and retain some level of control.

Stock-for-Stock Exchanges

A Type B reorganization is a stock-for-stock exchange in which the buyer pays for or “exchanges” your shares with stock in its own company. Simply put, you and the buyer are exchanging shares. In this situation, you receive stock in the buyer’s company, and the buyer receives stock in your company and your company remains as a stand-alone subsidiary of the buyer. A stock-for-stock exchange is most practical if the buyer is a publicly traded firm with a ready market for their shares, or if you don’t require liquidity now and see a strategic advantage in merging with the buyer. If the buyer’s stock isn’t readily traded, you will now hold illiquid shares and have difficulty cashing out the investment. Regardless, in most cases, you’ll have restrictions regarding when you can sell the shares and may argue for registration rights, which enhance your ability to sell your stock. A Type B reorganization’s primary advantage is that it’s tax-deferred since you won’t pay taxes until the new shares are sold.

Earnout

An earnout is a form of deferred payment that’s contingent on certain events occurring depending on the performance of your company after closing. An earnout can be tied to revenue, EBITDA, or a non-financial metric such as the retention of key employees or issuance of a patent. Earnouts aren’t magic bullets – they aren’t suitable for most transactions. Earnouts should primarily be used to bridge price gaps, mitigate risks, and incentivize you to remain with the business. 

If you and the buyer can’t agree on a price, you should determine the reason for the price gap. Once the cause is determined, you and the buyer can decide which mechanism is most appropriate to bridge the gap or address the buyer’s concerns. Start by evaluating your objectives, and then decide what deal structure is most appropriate to meet those objectives. Some buyers, particularly financial buyers, want to ensure you have as much skin in the game as possible after the closing and therefore commonly propose earnouts. In most cases, several of these tools are used collectively to mitigate the buyer’s risk and keep you on the hook for as long as possible.

Earnouts should primarily be used to bridge price gaps, mitigate risks, and incentivize you to remain with the business. 

A Clawback or Reverse Earnout 

A clawback is simply a reverse earnout. Money is given to you at closing and then “clawed back” if certain targets aren’t met. Instead of withholding a portion of the purchase price, you receive the entire amount at closing and must then reimburse the buyer if the goals outlined in the agreement aren’t met. Clawbacks aren’t popular with buyers or sellers – buyers don’t want to chase a seller down to get their money back, and sellers don’t want to give back the money they’ve likely already spent. Clawbacks are most common when money is provided to a business for expansion purposes, and the business owner hasn’t used the funds.

Employment Agreement

Employment agreements are suitable if you’ll continue to play a defined role in your business, and are commonly used in combination with earnouts to compensate you for your continued involvement in the business. Earnouts tend to be based on high-level metrics for the company, such as revenue and EBITDA, while employment agreements provide a base salary, often in the range of $200,000 to $400,000 for most mid-market companies.

Consulting Agreement

Consulting agreements are often designed to facilitate the business’s transition to the buyer. In most consulting agreements I see, the seller agrees to help the buyer on an ad-hoc basis for a flat hourly or monthly retainer fee and is available by phone, online, or email to assist with detailed transition matters. This is most fitting when the buyer wants to ensure you’ll be available to assist with the transition. In most consulting agreements, you won’t have control or influence over the performance of the business. The primary disadvantage of employment and consulting agreements is that they’re tax-inefficient for you because they are taxed at ordinary income tax rates, although they are deductible for the buyer.

Holdback

Most M&A transactions include some form of holdback, also known as an indemnity escrow. Note that the term escrow can also be used to refer to an escrow agent who is charged with collecting and disbursing funds at the closing. With a holdback, the parties appoint an independent third-party escrow agent to hold a portion of the purchase price, usually between 10% and 20%, to satisfy any post-closing indemnification claims. Because the funds are held by a third party, holdbacks offer the buyer a guarantee that funds are available if problems are discovered and the seller is unwilling or unable to make payments.

Holdbacks are tied to the reps and warranties and the indemnification section in the purchase agreement. They’re used to ensure the buyer can recover damages if the seller has committed fraud, made material misrepresentations, or otherwise made an inaccurate representation regarding the business. 

Representations and Warranties

Reps and warranties constitute about half of the content in a typical middle-market M&A purchase agreement. Representations – or “reps,” for short – are statements of past or existing facts. Warranties are promises that the facts will be true. In reality, reps and warranties are used interchangeably, and there isn’t a distinction between them. Reps and warranties are designed to force you to make key disclosures regarding your business before you sign the purchase agreement. If any reps and warranties prove to be untrue or are breached – in other words, if the seller knowingly or unknowingly lied to the buyer – the buyer has a right to indemnification through the holdback account. 

Reps and warranties are strongly debated in most transactions and often include minimums, maximums, and other mechanisms that are triggered when an indemnification claim can be filed. For example, if a minimum – usually called a “floor” – is $100,000, the buyer cannot file an indemnification claim if the claim is less than $100,000. Reps and warranties are fundamentally a method for allocating risk between the buyer and seller. If the buyer is concerned about certain specific risks in the business, it may be possible to address the buyer’s concerns through strongly worded reps and warranties instead. The reps and warranties can then be funded with a holdback.

Buyers can find many things with which to concern themselves. Most of the time, they’re simply being prudent. However, there are situations that can legitimately merit a holdback.

A buyer purchasing a manufacturing company may be concerned about the environmental condition of the property. Any type of business that has industrial activity is at risk for contamination. Assessment and cleanup of the property can be expensive, time-consuming, and risky. A buyer may be apprehensive that hazardous materials have leaked onto the property or that they have been stored improperly. 

This example is a sound reason to request a holdback. Another might be if the same buyer is worried about future liability to employees working on the property or nearby dwellings and their inhabitants. These things can affect the value of the business and can ultimately hinder its performance.

Another common concern to business buyers is fraud. This is understandable because we’re facing a time when fraudulent activities are at their height. In fact, the Association of Certified Fraud Examiners found that private companies have an occupational fraud frequency rate of 42%, mainly due to a lack of internal controls. Protection against fraud is another sound reason to request a holdback. 

Reps and warranties force you to make key disclosures regarding your business before you sign the purchase agreement.

Why is a holdback necessary?

Holdbacks give the buyer assurance that money will be available to cover their expenses from litigation and losses if, for example, any of your reps or warranties later prove to be untrue or for other breaches in the purchase agreement. 

One example is in the case of the sale of a manufacturing plant with considerable machinery and equipment. The seller may have represented that the machinery is operable and in good repair. If a piece of machinery breaks after the closing, and the buyer determines there was deferred maintenance on the machine and the problem was concealed by the seller, the buyer can file a claim to seek reimbursement for the machine.

This money is normally held in escrow for 12 to 24 months. The funds go into a holdback account of a neutral third-party escrow agent and are governed according to the terms of the holdback agreement. These funds are normally only released upon the buyer’s and seller’s mutual agreement. The holdback agreement defines the specifics of when the funds are released and the method for handling disputes. Most disputes are made in the last few weeks before the holdback period expires. If there are no claims at that time, the money is released to the seller. 

Are there alternatives to a holdback?

Yes. Most M&A transactions include some form of deferred payment, and nearly any deferred payment can also function as a form of holdback. Here are several alternatives:

• Promissory (Seller) Note: The promissory note can also include explicit language that affords the buyer the right to withhold future payments in the event of a breach – called an “offset.”
• Earnout: Earnouts can also include a right of offset; however, the likelihood of the seller receiving any earnout payments should be considered. The less likely the seller is to receive payments via the earnout, the less suitable an earnout is as a replacement for a holdback.
• Consulting or Employment Agreement: Consulting and employment agreements can also include a right of offset although this may not be allowed in certain states that prohibit what are known as setoffs against employment agreements. 

Sellers are likely to resist a right of offset against guaranteed, deferred payments, such as a promissory note and consulting or employment agreements. That’s because such arrangements afford the buyer a significant amount of leverage since the buyer “controls” the money. Allowing the buyer to simply withhold payments may afford the buyer too much power, and sellers may justifiably prefer a holdback.

What are the major terms of the holdback agreement?

The parties should consider the following terms:

• Amount: Most transactions include a holdback that ranges from 10% to 20% of the purchase price. The size of the holdback should correlate to the likelihood and magnitude of the potential risks and whether other forms of deferred payments also contain an explicit right of setoff. 
• Time Period: The period for most transactions ranges from 12 to 24 months, but I’ve seen holdbacks as short as 6 months and as long as 36 months. Most buyers prefer to prepare a full year’s P&L statement and close the books, so they can examine an entire accounting period, which is why most periods are at least 12 months. In most cases, two years is more than sufficient to uncover potential risks.
• Conditions: The holdback agreement should prescribe the conditions of the holdback and who controls its release, which is normally mutual, and how disputes are handled. 
• Interest: Who should receive interest on the amount held in escrow?

How are disputes normally handled?

Disputes regarding the purchase agreement will be governed by the terms of the purchase agreement in conjunction with the terms of the holdback agreement. In some cases, supplemental agreements, such as a non-competition agreement, may have separate dispute mechanisms. 

Most disputes will be governed according to the terms laid out in the “Indemnification” section of the purchase agreement. There’s no such thing as a “standard” indemnification provision. Indemnification language may be strongly debated by both the buyer and seller. 

In most cases, if a buyer discovers a problem or a breach, the buyer must notify you, and you’ll have time to resolve the problem – often known as the “right to cure” – contest the damage, or reimburse the buyer. If the parties can’t immediately resolve the issue, the money will remain in holdback while they attempt to reach a resolution.

A final question to consider is whether the holdback should be the buyer’s exclusive remedy or whether the buyer may be afforded additional remedies.

Royalties and Licensing Fees

Royalties and licensing fees are most applicable if tied to product sales. These fees are appropriate if you have a product in development that you expect to launch shortly but for which the revenue is difficult to predict. They may also be used if you have numerous other products in development, either owned by your company or independently. 

For instance, I recently encountered this situation with an online retailer of proprietary automotive parts. Fully 90% of the revenue was generated from one product line, but the seller had a second product line in development that, once launched, was expected to comprise 30% to 40% of the revenue. We discussed cordoning off the product line into a separate company, but that proved too difficult. In the end, we decided that a royalty or licensing fee would be the most practical approach.