After a long search, you've finally found your dream business.
The business is profitable, in your industry of expertise, and the owner is desperate to sell. Why hasn't it sold already? The owner has struggled to find a buyer with the necessary operational expertise.
Having all the leverage in the negotiation, you propose the following structure:
- You will buy the business for the asking price BUT the owner must finance 100% of the deal. So instead of using your own cash, you will pay for the business using the profits of the business over the next 3 years. You will also throw in a 20% bonus for reaching specific revenue targets.
This might sound like the perfect win-win deal - that's because it's fictional.
Unfortunately, buying a business isn't like buying a used car. You're going to need to put some money down.
So, 'can you buy a business for free?' the short answer is probably not, no. That said, there are a ton of mechanisms that allow buyers to reduce the risk of buying a business. The non-exhaustive list includes:
- Earn-outs
- Reverse earn-outs
- Vendor financing
- Equipment leasing
It is to your advantage (as both a buyer or seller) to understand what these terms mean. As they could make the difference in closing a deal.
Earn-outs
An earn-out is a payment arrangement between the buyer and seller. In most cases, this involves the Buyer offering part of the asking price with an up-front cash payment. The remaining balance is contingent on the business meeting performance metrics (revenue, profitability) over the next 12-36 months.
When to use it:
Earn-outs are great in a couple of different scenarios:
- A larger, strategic buyer is taking over your business. Especially when they can bump revenues/profits by selling to existing customers.
- When there is tremendous uncertainty about the future of the business (i.e. tourism during COVID-19). Earn-outs should balance the risk/reward for both the Buyer and Seller.
- When a company is anticipating uncharacteristic growth. For example, let's say you were the owner of a mask business before COVID-19. For the past decade, you have earned steady revenues of $300K-$400K/year. But in 2020, you sold $3M worth of masks. While this is an anomaly due to COVID-19, you (the Seller) believe you will maintain this level of sales through 2024. Whereas the Buyer thinks sales will drop back down to normal levels by 2022. To bridge this gap, you could include an earn-out to split revenues above a certain threshold.
What to look out for:
While earn-outs are useful, there are a few scenarios you need to look out for:
- Experienced buyers can take advantage of first-time Sellers with aggressive earn-out structures. For example, it may sound like they are offering you $1M for your business when it is really a fantasy offer. Meaning the $1M valuation has little to zero chance of materializing. Buyers do this by setting unrealistic revenue or profit earn-out targets - so keep this in mind.
- Another problem with earn-outs is the amount of work to track & report progress after the deal. When business owners sell their business - they usually want to be 100% removed from operations. This isn't possible if they need to revenue monthly or quarterly revenue reports. Making the on-going reporting work of an earn-out a chore.
Reverse earn-outs
Surprise! a reverse earn-out is an earn-out...in reverse.
This is where the Seller receives 100% of the purchase price up-front - with claw-back provisions. You can think of a claw-back provision like a refund - if the product you bought doesn't perform as expected - you may get some of your money back. But if the product meets your expectations - you pay full price. Reverse earn-outs works in a similar (but more complicated) fashion.
Seller financing
Seller financing (or Vendor Take-back Note) is a commonly misunderstood deal term. Included in most transactions, vendor financing is when the Seller 'lends' a portion of the purchase price to the Buyer. The Buyer then pays back this amount like a traditional loan. For example, if you had a purchase price of $100,000 with a 10% Vendor Take-back Note, the Seller would 'lend' the Buyer $10,000. The Buyer would pay back the $10,000 over the next 24-36 months at some nominal interest rate.
When to use it:
Seller financing is a great tool to ensure the Seller still has some 'skin in the game'. Like an earn-out, it is in the Seller's best interest for the business to continue operating well. Earn-outs also protect the Buyer from misrepresentations about the business from the Seller.
What to look out for:
As a Buyer, it is tempting to make an offer where 100% of the purchase price is seller-financed. While this is attractive from your perspective as a Buyer - it is very unattractive to the Seller. Think about it this way - you would want to be the Seller's bank? This is how the Seller will view financing you as part of the deal.
Equipment Leasing
The sale of asset-heavy businesses (machinery, vehicles, tools, etc.) is often distracted by valuing these assets. Buyers worry the equipment is in not good condition (which could mean big replacement costs in the future). Whereas the Seller wants to receive a fair price to what they originally paid. It is not uncommon for this debate to kill a deal.
One way to mitigate this deal killer is by leasing back the existing equipment. This also works when the Buyer doesn't have all the capital necessary to buy the equipment.
It works by leasing existing equipment back to the equipment provider.
This is beneficial for 2 reasons:
1) a 3rd party establishes the fair market value of the assets
2) the buyer gets more flexibility (they can continue leasing the equipment or buy new equipment in the future).
Wrapping up
In a small business transaction, complex deal terms can cause more pain than they are worth. That being said, when used correctly, they can make the difference in getting a deal done.
Thinking about buying a business? Make sure to read our article about the Red Flags You Should Know Before Buying a Business 🚩
