Selling out

 

guest commentary by David Potts

Starting a business is tough. Many, if not most small businesses fail within five years of their start date. Sometimes the failure is due to lack of capital. Sometimes the failure is due to a bad idea. Sometimes the failure is due to an inability to manage.

For many people it is the American dream to own their own business. But it seems most people that want to own their own business think they need to start it from scratch. Maybe that’s because most of the books on the shelves in Books-a-Million praising entrepreneurship are about starting a business. But for many future business owners, the best option might be to buy an existing business. Their main obstacle? Lack of money.

In today’s business environment, when compared to the recent past, it is more difficult for a buyer of a business to get bank financing. Credit standards have tightened. The value of many businesses is in the intangible assets, assets which the bank can’t use as collateral. So if a buyer can’t get financing from a bank to buy a business, is this the end of his dream? Not necessarily. It is just as likely to be the end of the business seller’s dream of retiring if there are no buyers capable buying their business.

Baby Boomers are getting old. I know. I am one. Many Baby Boomers own businesses where they have invested their lives. They have been successful in their business, a fact a potential buyer would be wise to notice in everything except a plan of succession.

And if banks have difficulty loaning money to aspiring entrepreneurs, then sellers can find themselves in a difficult situation. How are they going to cash out the value of their business? If you are a Baby Boomer, how long can you wait until the economy cycles back to easy credit? Isn’t the future really one of higher interest rates, higher taxes, and inflation? So if a business owner wants to sell his or her business, seller financing may be their best option. It may be the only option for some businesses.

I spoke with a couple of business brokers to get a feel of the current market for buying and selling businesses. The current market is requiring seller’s to be involved in financing the sale of their business.

Dawayne Murdock, a business broker with CBI Sunbelt of Fort Smith said, “a business owner who wants top dollar for their business must understand the need and the advantages of owner financing.”

As a CPA advising my clients, I have been biased against seller financing. My point to my clients has been “you are trying to get out of business, why do you want to get into the lending business? That is what a bank is for.” But in today’s environment, I am modifying my long held position that a seller shouldn’t finance the sale of their business. A bit. But not completely.

If you are a business  owner at the point in life where you feel it is time to sell your business, remember Cash is still king. If you can sell your business to a cash buyer for its full value, this is always your best option. But if you can’t find a cash buyer, there are advantages to seller financing, IF you can manage your credit risk.

The biggest advantage, as Dawayne said, is selling your business for top dollar. A cash buyer may expect a lower price since they are paying cash. I would. But a business owner financing the sale of their business to a buyer with limited borrowing capacity has the upper hand in negotiating the sale. According to The Business Broker Online Magazine, studies show that on average, a seller who sales their business for all cash receives only 70% of their asking price compared to 86% of the asking price for sellers who participate in financing the sale of their business.

Once you sale your business, what are you going to do with the money? I don’t see anybody getting rich investing in certificates of deposit. I think the last interest rate I received when I renewed a CD was less than 2%. Although you are subject to usury laws in Arkansas, you could still carry a note for 5.75% (5% over the Federal Reserve Bank’s discount rate which is currently .75%) which is substantially higher than certificate of deposit rates.

A seller financing the sale of their business might also benefit from the Internal Revenue Code’s installment sale rules which allow you to spread the income tax on the gain on the sale of your business over the years in which you collect the money from the buyer.

This could mean lower income tax on the gain. However, this is where you need professional tax help. With tax rates going up in 2011, you might want to elect out of the installment sale rules and pay the income tax on the gain in 2010. This will be dependent on your particular tax situation. Call your CPA for advice.

But here is the problem with financing all or part of the sale of your business. If you finance the sale or part of the sale of your business, you are a creditor. As a creditor you are at risk of losing your money just as any other creditor would be. So it is important that you know how to minimize this risk of loss.

One thing you can do to minimize your risk of loss is to make sure the buyer is at risk of loss too. The buyer needs to commit a significant portion of his net worth to buying the business. If the buyer can’t come up with a decent down payment, don’t finance the sale. He or she would have nothing to lose by walking away from the note after he destroyed your business. You, the seller, would have a lot to lose.

Treat the buyer as you banker used to treat you. Get a copy of the buyer’s personal financial statement. Analyze it. Analyze the character of the buyer. Do your due diligence on the buyer. At a minimum investigate the buyer as much as you would before you hired a key employee. Ask for a resume and look at the buyer’s business experience and the experience in your type of business. Check the buyer’s references, perform a criminal background check, and review his or her credit report.

Try to get a bank involved. If you have been in business a long time you surely have a close relationship with a commercial loan officer. Take him to lunch and get his advice on analyzing the credit risk associated with the buyer. See how much your bank might be willing to finance for the buyer. There is no reason you have to carry 100% of the purchase price, even if the bank will only loan 30% or 40% of the price. You are still reducing your potential risk of loss.

Finally, stay involved in the business while you carry a note. Require the buyer provide you current financial statements as a condition of financing the business.  Place restrictions on how much the new buyer can take out of the business until your note has been paid. Make sure you are collateralized as well as the business assets and the personal assets of the buyer allow.

A business owner cannot always choose the perfect time to sale his or her business. Life events sometimes choose the time for you. But even in the current economic environment you can sale your business to capture its fair value. It may take more time to find the right buyer and it may take some flexibility on your part in structuring the terms of sale. But it is still possible to finish on top.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

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