Get­ting the price you want when you sell

Finweek English Edition - - BUSINESS - By Gareth Ochse

In sell­ing any as­set, there are two fac­tors that work to­gether hand in hand to com­prise “the deal” – price and terms. The money you re­ceive from the sale of your busi­ness and when you will re­ceive it.

In the­ory, you could have an in­fin­itely high price for the busi­ness if you were to ac­cept in­fin­itely long pay­back pe­ri­ods and low in­ter­est rates, or you can have an all-cash deal paid im­me­di­ately, but at a much lower price.

What hap­pens when you have a buyer who can pay only R1m, in­clud­ing all the money he can raise from his com­mer­cial bank, yet the seller wants R1.5m? How do you strike a deal to make this hap­pen? The an­swer is that the seller needs to fi­nance the re­main­ing R500k of the sale, in the form of a prom­is­sory note where the buyer makes pay­ments to the seller over time. This is called seller carry-back fi­nanc­ing. It’s in­ter­est­ing to see where the ac­tual be­havioural ranges sit: as statis­tics on sales of SMBs over the last 1997-2012 pe­riod in the US show: 1. In only 40% of deals was the seller paid 100% of the price in cash on clo­sure, with the seller pro­vid­ing some fi­nanc­ing in the other 60%. 2. The amount of fi­nanc­ing pro­vided ranged from 10% to 100%. 3. The mix of deals with 20%, 30%, 40%, 50%, 60% and 70% paid in cash was fairly even. Very few had 0%, 10% or 80% or 90% cash. 4. Most sell­ers f inanced their deals at 6% to 12% over the pre­vail­ing cost of a bank loan. 5. Deals were typ­i­cally f inanced over 4.5 to 10 years, but the range var­ied from 1 to 20 years. 6. 100% cash deals were typ­i­cally priced 20% lower than deals where

the seller pro­vided fi­nanc­ing. The sig­nif icant part of this is that seller fi­nanc­ing hap­pens 60% of the time and where the seller fi­nances part of the deal, the typ­i­cal price achieved is 20% higher than 100% cash trans­ac­tions.

That’s a po­ten­tially huge pre­mium to be earned in ex­change for tak­ing on more risk. The other points sug­gest that the deal struc­ture it­self is highly ne­go­tiable, with a range of in­ter­est rates, re­pay­ment pe­ri­ods and up­front pay­ments.

If it was easy to com­pute an “aver­age” deal, it would prob­a­bly carry a fixed in­ter­est rate of 5% above com­mer­cially avail­able credit, be re­paid over five years and pay 50% of the price in cash. Note that in­ter­est rates have to com­ply with Usury laws.

It’s easy to think that the sell­er­fi­nanced deal gets a 20% price pre­mium only be­cause the buyer isn’t pay­ing the full price with his own money and thus feels free to spend, but that’s not the whole pic­ture: what the seller does, by agree­ing to fi­nance the deal over time, is to share in risk. By do­ing so, the seller signals that the deal is worth back­ing and that in­creases the con­fi­dence of the buyer who then is will­ing to pay the higher price. There is risk to the seller, how­ever: seller fi­nanc­ing is of­ten done be­cause the buyer can’t af­ford the re­quired com­mer­cial credit fa­cil­ity; typ­i­cally be­cause he has a poor credit his­tory.

This is why the terms of the deal are of­ten 5+ years – it’s enough time for the buyer’s credit his­tory to clear and for him to t hen be able to raise com­mer­cial fi­nance to cover the out­stand­ing amount, which is of­ten struc­tured as a bal­loon pay­ment. Ob­vi­ously there’s a risk that a per­son who isn’t cred­it­wor­thy to be­gin with stays that way and the deal falls apart, in which case the seller is prob­a­bly left with only the cash por­tion he re­ceived up­front. The buyer may also run the busi­ness into the ground and be un­able to make the re­main­ing pay­ments. Given the in­her­ent risks in SMBs, the 20% price-pre­mium achieved starts to sound low.

I noted ear­lier that sales dataset ref lected sales up to the end of last year. In early 2013, the US govern­ment passed up­dates to the Dodd-Frank act (which was a sweep­ing re­form of the whole f inan­cial sys­tem in­tro­duced in 2010). Part of the act re­quires all res­i­den­tial mort­gage loans, in­clud­ing seller car­ry­back f i nanc­ing, to be ne­go­ti­ated by li­censed mort­gage orig­i­na­tors.

In other words, of­fer­ing th­ese loans is treated as a f inan­cial ser­vice and is now reg­u­lated. Al­though some loop­holes/ ex­clu­sions re­main, re­pay­ment pe­ri­ods, in­ter­est rates, due dili­gence on the cred­it­wor­thi­ness of the buyer, and more are all now stip­u­lated by the act.

How much the Dodd-Frank act will im­pact on seller-fi­nanc­ing in the sales of SMBs (as op­posed to mort­gage-backed prop­erty sales) in the US re­mains to be seen, but its pop­u­lar­ity and pre­mium sug­gest its cer­tainly some­thing you want to con­sider when buy­ing or sell­ing a busi­ness. While nor­mal ranges ap­ply, ev­ery­thing is ul­ti­mately ne­go­tiable and two par­ties with suff icient f lex­i­bil­ity will al­ways get a deal done. If you have a ques­tion/is­sue you’d like to dis­cuss with us, then send an email to fin­week@val­u­a­tionup.com

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