All You Need - is Financing.
Figuring out how to finance the transaction is a threshold issue as much as agreeing on the price, as it will make or break the deal.
Most people are aware of the concept of a “mortgage” – to buy an asset (usually a home) using a loan (usually from a lender) that if not paid back in a timely manner, will give the lender a right to sell that asset to pay itself back. However, there are many more forms of financing, in varying degrees of complexity, based on how willing (or desperate) the parties are to get a deal done. In all, there are four ways in which to finance a deal: (1) buyer’s cash (simple enough); (2) seller-financing; (3) bank or private lender or small business administration financing; and (4) a combination of the above.
(FYI: this is an excerpt from my 15-page e-guide, “Seven Ways to Better Deals”, which you can get for FREE when subscribing to my Weekly Newsletter.)
The Buyer’s Cash. It is unlikely that a buyer will avoid using its own money to finance a deal altogether - no one is that good of a negotiator. Often, the deposit to secure the deal is financed with the buyer’s own cash, and if the buyer wants to use institutional financing (see below), it would be required to “put its own skin in the game” with 10% to 20% of the purchase price being sourced from the buyer. This makes sure that the buyer believes in the deal sufficiently enough to risk its own money. It’s often in the buyer’s advantage to maximize the amount of cash it puts up in a transaction; by providing more cash, the buyer de-risks the position of the lender and therefore, may find itself enjoying a preferred interest rate or less stringent requirements like a requirement of a full guarantee. The buyer will also enjoy greater leverage against the seller, who might forgive a lower purchase price if that means less seller-financing and more cash in the seller’s pockets on closing day.
Seller-Financing. In upwards of 90% of business deals (although not nearly as often in real estate deals), the seller would act as the lender of last resort by negotiating a promissory note with the buyer, whereby the buyer would owe the seller a portion of the purchaser price over the course of years (often 3 to 5 or 7 years) at a commercially reasonable interest rate of 5% to 8%. Two goals are achieved this way: (1) the seller can ask for a higher purchase price and just agree to be owed some money over time, signaling to the buyer that the seller believes in the transacted asset’s or business’s long term success, and (2) the seller takes on some of the risk of buying the asset or business from the buyer, remaining interested in the buyer’s success for years after the closing. Moreover, the buyer can more easily finance the now-smaller remaining balance of the purchase price with institutional lenders, whose terms are less flexible and more demanding on the buyer as borrower.
Additionally, lenders charge origination fees, closing costs, and take their sweet time underwriting the loan. Some of the disadvantages of seller-financing include the truncated repayment period, where a lender (say, via an SBA loan, see below) would often agree to 10 or more years of amortized payments.
Institutional Financing. The vast majority of small business acquisitions are financed with Small Business Administration (“SBA”) loans. While one can definitely secure financing outside the scope of the SBA, there really is no reason to. The SBA doesn’t actually loan out the money but rather, acts as the guarantor for banks that do in case the borrower defaults. So long as the banks follow the guidelines of the SBA, the loan is “de-risked” and is therefore more likely to be issued. Often, an SBA loan offers the best possible financing available for buyers, reducing or eliminating the need to have seller-financing, which are usually at higher interest rates and for a shorter term. While an SBA loan might be a harder hurdle to jump through, with more paperwork, appraisal and closing costs, and a longer wait time to have the bank underwrite the transaction, it should, however, result in a greater cash-on-cash return, higher operating income and lower debt service for the buyer. For the seller, this is as good as having a cash buyer.