When selling a business, there are a few ways the purchase price can be handled. For this post, assume the business being purchased has an agreed value of $1,000,000.
- Cash at Closing. The simplest transaction is cash at closing. The buyer writes a check to the seller fro $1,000,000 and the deal is done. Most often the buyer has actually obtained a loan for the purchase price. But from the seller’s perspective, she doesn’t care if the check is from buyer or his lender. The seller is paid in full as of the closing, and the deal is done. Simple.
- Seller’s Note. The seller is often asked to provide part of the financing for the sale of their own business. So the buyer brings $800,000 to the closing as a check (either their own money or from a lender) and executes a promissory note to the seller for $200,000. The key to negotiating for the seller is to get the amount of the note as low as possible (thereby getting more cash at closing), keep the duration of the note as short as possible (the long the duration, the more risk of default), and secure the note with the assets of the business, buyer’s personal guarantee, or both. Seller’s notes are common when the buyer is paying by way of an SBA loan. Often these loans require a certain portion of the transaction to be paid as a seller’s note, and often with a full two year waiting period before payments to seller even begin.
- Earn Out. The highest risk for seller is an earn out. This is similar to the seller’s note above, but the amount the seller is financing is not fixed. It’s based on the success of the business after the sale. So the buyer brings $800,000 cash to the closing. But instead of setting the remaining amount of $200,000 in stone, the buyer agrees to pay a percentage of revenue or profits for a period of time. Perhaps buyer agrees to pay seller 5% of revenue monthly for two years. Seller takes the risk that the buyer won’t earn as much as expected, thereby reducing the amount paid to seller. Like the seller’s note, sellers should try to reduce the amount dedicated to an earn out, and reduce the time the earn out will be paid. The only time when this is not true is when the seller has strong confidence that the buyer will actually grow the business after the sale. If so, the seller would enjoy that growth through his percentage of revenue. Finally, seller’s should always seek to have the earn out calculated based on gross revenue and not based on profits. Profits are far too easy to manipulate and disagreements are almost certain as to how to calculate the amount to be paid to seller.
Each of these types of transactions could be a series of posts on their own. There are far more details and nuances. And there are also several far more complex transaction structures out there to maximize tax advantages, etc. But these cover the basic three concepts behind selling your business.
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