Buyers and sellers of businesses sometimes become fixated on the final price. However, the way that price is paid may be more important than the actual number. It’s rare that a business is completely paid for in cash. That means the rest of the sale has to be financed through a variety of financial tools, including loans, promissory notes, earn outs, and seller financing.
The trick is to find the right mix of cash, lending, and other financing that works for all parties involved. That’s tough to do if you’ve never been involved in a business transaction before. The jargon used in deal negotiations sometimes sounds like its own language.
If you don’t know an earn out from a promissory note, you’ll need to brush up on deal terminology before you jump into negotiations. The following is a good primer to give you an understanding on the basics.
The ingredients of a deal
Cash may be king, but it’s usually not the primary source of funding in a financial services practice transaction. Few buyers purchase practices for all cash. That’s because they may not have enough cash to do so and also because they may not want to commit that much cash into a practice upfront.
Sellers, on the other hand, often want to get as much cash as possible out of the deal. If the buyer can get lending, that could satisfy a seller’s cash requirement. However, if the buyer can’t get traditional lending, the buyer and seller may have to look to alternative funding methods.
One popular financing method is an earn out, which is a predetermined cash payment to the seller that is tied to some kind of practice measurable. The selling advisor may receive a payment if a certain percentage of the client base is retained after the transition or if a certain number of transactional accounts are converted to fee-based. Earn outs are popular because they give the seller an opportunity to earn more money while also satisfying the buyer’s concerns over how the practice will perform after the transition.
Seller financing is another way to fund a financial practice transaction. In seller financing, the selling advisor acts as the buyer’s lender. Rather than make loan payments to the bank, the buyer makes payments to the seller. The advantage to this is that it could expedite the transaction. The downside, from the seller’s perspective, is that the seller now has a very real interest in the success of the firm after his or her departure. The seller will also likely receive the seller-financed portion of the compensation over many years rather than upfront.
A broker dealer could also be in a position to help finance the deal by offering a promissory note to the buyer. A promissory note is essentially a loan agreement. In this case, the broker dealer could pay the seller for the practice and then the buyer could make regular payments to the broker dealer until the note is paid off. This gives the buyer financial flexibility, but also helps the seller receive more compensation upfront.
Communication is key to finding the right mix
Finding the right allocation between cash, earn out, and lending requires transparent and forthright communication. If a buyer knows and understands your goals as a seller, he or she can work with you to find a deal that works for everyone. A broker dealer also may be in position to facilitate the deal, so it’s important to inform them of any potential transaction as early as possible in the process.