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Holdbacks, Seller Financing, & Performance Financing
By Quiet Light
It is no surprise that many people who are looking to acquire an online business look to find a business where the owners are willing to finance a portion of the asking price. However, while most buyers would strongly prefer to finance a portion of the purchase price through owner financing, most sellers will be strongly opposed to that idea.
With this difference of opinion on financing, how should you approach a seller if you want to finance a portion of the purchase? What types of businesses lend themselves the best to financing?
Why Sellers Dislike Owner Financing
Many buyers do not understand why a seller would dislike an offer that includes owner financing. After all, some styles of financing can actually result in the seller receiving more money in the long run. Additionally, seller financing can open up more offers which in turn would likely result in a higher price for their business.
Yet even with these incentives for owner financing, it is very rare that a seller will prefer financing the sale of their business. There are several reasons for this:
Most Sellers Cannot Collect on Defaults
The very first question sellers tend to ask when approached with owner financing is “what do I do if they don’t make their payments?”. In theory, default payments can result in having the sold assets repossessed by the seller. The reality, however, is that most sellers do not want to take on the repossessed assets and associated work with owning those assets again and also do not want the potential hassle and cost of trying to repossess the assets.
Most Sellers Want to Move to New Opportunities
Owner financing requires that the seller stay involved with their business at least insomuch as they are collecting payments. Most sellers are looking for a clean break from their business. They want to move on to something new, something more exciting (at least to them), and something different.
Most Sellers Want the Simplest Solution Possible
Although seller financing can actually be fairly straightforward, most sellers want as clean of a break as possible. Seller financing stretches out what is already a very stressful transaction into several months of waiting for that transaction to be completed. All cash deals are highly desirable for them as it gives maximum flexibility and the quickest route to their next opportunity.
Who Likes Delayed Gratification?
In general, people dislike delayed gratification – especially on the Internet. Working on the Internet is working in a world of immediate results, immediate feedback, and usually immediate payments. The idea of having to wait for payments in incongruous with how online business owners think and work. Some people prefer to have a steady, reliable cash flow, but most online business owners will prefer the immediate reward of cash upfront.
The Market Dictates: There are Usually All Cash Buyers
Possibly most importantly, for most quality Internet businesses that are for sale, there are buyers who are willing to pay cash and close quickly. Given the motivators above, and given the ample supply of cash buyers, most sellers won’t even entertain financing offers.
Despite this, however, there are many businesses which sell that have portions of the purchase price wrapped up in some form of financing. Below we will talk about three types of common owner financing.
Common Types of Owner Financing
1. Performance Based Financing (Aggressive)
What Is It?
Performance based financing, which is essentially in the same category as ‘earn outs’ or ‘revenue shares’, involves making payments based on the future performance of the business. Consider the following examples:
Payments based on triggers. A business is purchased for $150,000 cash at close. After 6 months, should the business exceed an average monthly gross revenue of $10,000 (or a total gross of $60,000 for the 6 month period), this will trigger an automatic bonus payout of $50,000.
Revenue Share with Floor. A business is purchased for $350,000. For every month that the total revenue exceeds $10,000, a bonus payment will be made totally the amount in excess of $10,000 * 3. So if the business grosses $12,000 in a month, a bonus payment of $6,000 will be made. The formula becomes: Total Bonus Payout = (Total Gross Revenue – $10,000) * 3. These transactions can also have ceilings which limit the total amount being paid out.
Straight Revenue Share. A business is purchased for $350,000. In addition, the seller will be entitled to 5% of the revenue for the next 24 months. These payouts can often have a ceiling on them as well.
When It is Used
Performance based financing is most typically used (and agreed to) when a business is trending strongly in one direction. Most commonly this tends to be the case with businesses that are trending heavily downward or have some other distressed nature to them. On occasion, a business that has extremely strong trends towards growth will require or want performance based financing so as to cash in on that future growth.
Performance based financing is one of the most aggressive types of financing available. The entire concept of this type of financing requires that future payments be made (or not made) based on the future success of the business. Buyers tend to love this type of financing as it greatly reduces risk. Sellers tend to strongly oppose this type of financing as it relies on the skills and talents of the new owner to reach certain benchmarks and places the value that they receive from their of the business strongly in the hands of a new owner.
It is for this reason that performance based financing deals are really only agreed to on businesses whose trends are strong in one direction or another.
2. Straight Financing (Neutral)
This type of financing is the easiest for most people to understand as we are all very familiar with taking out a loan.
What Is It?
Straight financing involves taking out a note with interest on a portion of the agreed upon asking price and paying that note back over an agreed upon term.
A business is purchased for $150,000 with $120,000 cash at close. $30,000 will be paid back over 12 monthly payments at a 6% interest rate.
When It is Used
Straight financing can be used on many different types of businesses, however, it tends to be agreed to when their is either a very strong connection between the buyer and the seller, or when the seller has had difficulty finding a buyer for their business.
Sellers generally will expect to finance no more than 20% of the purchase price of their business. In addition, most sellers will require that the loan be paid back within 12 months. The longer the term of the loan, the greater the chance that it will not be paid back fully.
They key to approaching a seller with a straight financing deal is to keep it simple, straightforward, and safe. Do not be surprised, however, if the seller simply balks at the idea of financing any of the purchase price. As was mentioned earlier, with plenty of cash buyers in the marketplace, sellers will typically prefer to get all of their money upfront.
3. Holdbacks (Passive)
Holdbacks are often times not considered to even be financing. However, they are common enough to consider here.
What Is It?
A holdback is a nominal amount of money that is held back from the closing date and is paid out within a short amount of time later.
A buyer acquires a business for $300,000. $270,000 is paid at close and $30,000 is paid after the training period of 30 days.
A buyer acquires a business for $300,000. $270,000 is paid at close, $15,000 is paid after 30 days to cover training, and $15,000 is paid after 90 days to cover returns of purchases made during the previous owner’s ownership.
When It is Used
Holdbacks are used primarily to keep the seller involved and engaged through training periods and to cover any incidental charges on that may be the responsibility of the previous owner. Straightforward and simple businesses typically do not have holdbacks.
Sellers are usually very open and receptive to holdbacks as long as the amount is nominal (usually 10% of the purchase price) and the timeframe is short (usually 30 days). In addition, some sellers will ask that the holdback amount be kept in an escrow account or held by a third party in the event of a dispute.
Tips for Securing Owner Financing
Transactions with owner financing are relatively uncommon (except for holdbacks). If securing owner financing is something that you insist on having in a transaction, here are some tips which may help you get an owner to agree to finance a portion of the purchase price:
1. Recognize Their Risk. Too often deals fall apart because one or both of the parties involved fail to recognize the risk that the other party is taking on. Owner financing requires a lot of trust from a seller, and while a buyer is always taking on a significant amount of risk, seller’s will question whether they need to take on what may appear to be an unnecessary risk. Recognizing the seller’s risk will help you in speaking to their needs and crafting a proposal that makes sense for all involved.
2. Keep It Simple. Although creating a tiered payout system complete with balloon payouts and performance escalators might ultimately be the best solution for everyone involved, creating a complex deal will usually result in outright rejection. Remember that in most transactions a seller (as well as a buyer) is trying to protect their interests. They protect their interests by being sure that they understand all that is involved in your offer. Complex payouts introduce too many ‘what ifs’ for sellers to feel confident that it is a good offer.
3. Keep it Short. The primary concern for sellers with owner financing is always whether or not they will be able to collect on a default payment. Shorter financing periods gives you fewer opportunities for defaults, and as such, reduces the risk for the seller. Shorter payouts also help satisfy a seller’s desire for relatively quick gratification and the ability to move on to their next projects.
4. Be Willing to Personally Guarantee. In many of the transactions we have consulted on our buyers have been happy to personally guarantee the loan. No financial institution would lend on an e-commerce acquisition without sufficient assets as collateral, and as such an individual should not be asked to do so either. Personal guarantees help seller’s know that you have every intention of paying back the loan in good faith.
5. Be Prepared for Rejection. Many seller’s would prefer to simply hold on to their businesses rather than sell them in a financing operation. As such, be prepared for most sellers to turn down owner financing deals. In addition, do not expect to financing a majority of the transaction unless the business is in distress.
Owner financing can be a good option for the right business. Many of our buyers have come into very strong businesses while utilizing owner financing to help leverage the upfront cost of acquiring that business. Owner financing can be obtained in some transactions. Knowing what to expect, the types of offers you can potentially make, and what motivates sellers can help you create a strong winning transaction for all involved.