First understand the tax implications and determine what the business is worth. Then take the time to know your options in terms of financing the deal
I am negotiating with the owners of the business where I've worked four years as business manager. I want to purchase the business, and they want to sell to me. I want to do an up-front cash payment, a term loan, and a portion of the total purchase price tied to future performance of the company. Do you have any suggestions?
—P. H., Mt Vernon, Wa.
This is a tricky time to buy a business since bank financing is so difficult to get. But you've got two important things going for you: You obviously like and trust the sellers, and they feel the same way about you.
You should also recognize that you are the sort of ideal buyer that most sellers dream about, says Stanley D. Crow, president of Boise (Idaho)-based S. Crow Collateral Corp: "You know the business, you have a track record of successful operation of the business, the seller has confidence in you, and the seller hasn't had to pay someone to find you as a potential buyer." Use these advantages wisely, and you could get a bargain, he says.
You don't say whether your intention is to buy the ownership of the business entity or the business assets, but you should get advice from your attorney and tax adviser on this. There are different tax and liability implications to each kind of sale, Crow says. You may also want to get a professional valuation of the business even if you think you know how much it's worth. "The right price for this business is determined not only by what it can produce for you but also by what a similar investment elsewhere would produce," he says. Talk to the sellers about splitting the cost of a valuation.
The proposal that you're putting forth—with a provision that ties the total purchase price to the company's future operating results—is called an "earn-out," Crow says. It's a common sales structure and can be quite effective, but it has some pitfalls. "In a very practical sense, the seller and the buyer will be partners during the earn-out period. It's important that they want to be in business together and that procedures are put into place right from the start to handle the inevitable tensions," he says.
If you definitely want to use an earn-out model, Ron Hottes, president of the California Association of Business Brokers, recommends that you structure the sale with a down payment equal to the sellers' discretionary earnings. Those earnings are defined as: net income before taxes; owners' compensation and perks (such as health insurance, company cars, and travel); interest; depreciation/amortization, and non-recurring expenses.
The balance of payments could be made with a fixed-amount term loan and an earn-out note or with an earn-out note only. "An earn-out note can be structured for a number of years or it can be structured around a fixed amount," Hottes says. It's typically a monthly payment equal to a fixed percentage of the previous month's gross sales.
If you're not wedded to the earn-out provision, there may be better alternatives, Crow says. You could propose a fixed price for the business and ask the seller to carry the paper for some portion of the sales price (say, 25%) but with part of the interest deferred into the future to allow time for revenue growth.
Another way to minimize your debt early on would be for you to purchase a portion (say, 75%) of the business now and give yourself the option to buy the remaining portion of the business within a specified period. "The price for that remaining percentage of the company could be determined by appraisal when the option is exercised," Crow says.
The seller would likely want the right to require you to buy the rest of the company whether or not you exercised your option, he says, but this type of deal would allow the seller to participate in the company's future growth and give you a pass on paying interest on the full purchase price as you get the company running under your leadership.
One important thing to remember in this economy: The performance of the business over the next two or three years might not be up to par, so make sure you're not paying a price based on historical performance. "If the state of the general economy may adversely affect the business, the purchase price and other terms should take that into account," Crow says.