Lender of Last Resort Will Get Your Business Sold
The lender of last resort for an asset class in oversupply is often the seller. Small business represents such an asset class.
The ATO considers a business with a turnover of less than $10 million to be a small business. Different laws define ‘small business’ differently.
The reason for the oversupply is largely because of the aging population.
As the older generation seeks to transition into retirement, they leave behind them an overhang of businesses where the level of demand is weak.
The Prices of Passive Assets vs Active Assets
That is one reason for their static prices compared to the upward spiralling prices of passive assets.
A comparison of the multiple of earnings paid for a house compared to the multiple of earnings paid for a business makes this abundantly clear.
A house produces an income equivalent to about 5% of its price.
The earnings from a business can be as low as about 20% but are more often 33%, 50% or even 100%.
Houses have rapid population growth from natural causes and immigration to drive demand. This strong underlying demand does not exist for businesses.
Another reason for the low level of demand is the lack of finance as an input to leverage the demand.
Sellers are only slowly coming around to the need to be the lender of last resort in the sale of their small business.
I have written some time ago about the comparison of business prices to house prices.
The points I made then have not dated. In fact, they have strengthened and are worth reading again.
As a business broker, I never counsel a buyer to approach a bank directly, hoping to get finance to purchase a business.
Banks don’t know how to lend money to buy businesses.
All you end up doing is leaving a trail of finance application rejections. This next time you are after financing, you may will run into difficulties.
Doors will start closing.
My advice is to use a finance broker.
Finance Means Help From a Bank or a Seller
They can weave the story together to get the best chance of getting the finance. Even then, you are likely to get a home loan with a fancy label.
Property will secure the finance and the borrower will pay a higher rate because it is being used for business.
Our banking system penalises borrowers who want to be productive. They much prefer to clip the ticket of rent seekers.
There is an exception to this that my accountant colleagues have corroborated. Judo Bank will lend based on the underlying strength of a business.
They rely on a more intuitive approach to determining the risk profile of a loan. They will provide loans based on the business without property security.
There is another source of finance to help facilitate a business sale. I have written about it partially in an article about how to get 25% more for your business.
This article talks about earn-outs which are a type of vendor finance. A more technical set of terms for lender of last resort.
There are many business owners who rely on the sale proceeds of their business to act as a proxy superannuation fund. The sale proceeds are the final piece of their retirement.
Converting their business into cash is an important milestone in realising this ambition. There are a couple of steps they can take to stack the odds more in their favour.
Consider a baby boomer who seeks to retire and whose proceeds from the sale of their business are a vital part of their retirement planning.
Assume that the income and profit of the business are greater than the wage of someone who would manage the business.
This assumption is important because it allows the idea of a buyer taking over the business from a baby boomer and employing a trusted associate to run it.
The income and profit of the business will pay for the manager while still leaving income and profit for the owner to enjoy. After they bed things down, the new owner can start looking for their next target.
If you think this isn’t happening now, then think again.
Increase the Chance of Selling Your Business
If you are an owner of a business that will support this idea, there are two things you can do to support it.
The first is to ensure that you run the business efficiently enough to produce a surplus profit.
You cannot play the role of the owner who simply throws more people and resources at a problem within the business.
The profit must support the payments to the seller who is the lender of last resort.
Don’t be the business owner who is content to get an absolute return from the business that will meet current lifestyle needs. Be an owner that looks at the return on investment.
It is the relative return of the business that is critical once you get over the minimum income and profit needed to sustain a manager. Looking at the absolute return leads to inefficiencies.
The second is to help a buyer fund the purchase. Being a lender of last resort to a buyer does this. It can provide the missing piece in putting a deal together.
Being a lender of last resort or vendor finance occurs where a buyer pays a deposit for the purchase of the business, with the balance being paid over a period.
The profits of the business will help to meet these commitments.
There are various ways of trying to negotiate the terms of vendor finance arrangement.
Typically, the seller will want as much as possible of the sale price up front. In various deals that I have concluded using vendor finance, the average amount up front has varied from 60% to 80%.
The seller will also want to be paid out as soon as possible. My experience has showed this to be between 6 months for smaller deals and up to two years.
Sellers may be reluctant to go beyond that time because the risks expand.
If they need to take over the business again because of a default, the damage to a business may be too large to recover if they have been out of the business for too long.
Of course, a buyer can offer other collateral. But typically, that is not available.
Vendor Finance and Earn-Outs
Buyers may ask for an earn-out as the vehicle for financing. Here, the business must hit key performance indicators as triggers for payment. This can be a way of sharing risk.
Although it represents a more complex way of selling a business, it is worth considering. It still counts as a method of being a lender of last resort.
There are some points worth considering in relation to earn-outs.
Stick to the KISS principle. Keep it simple.
An earn-out that is related to net profit leaves a lot of room for argument. Who is to say that the way the buyer operates the business stays the same as when the seller operated it?
Gross profit may be a better measure, but the price has already factored in the risks and volatility related to that. At least it is more relevant than net profit.
Turnover is a simple measure to use as an indicator, although the underlying profit may relate to turnover in too elastic a way.
The best earn-out indicator is probably one related to the handover of the business.
The seller can promise to be on the business premises for a period to ensure a smooth transition. That is something that a seller has a better chance of ensuring than profit measures.
An earn-out can work both ways. A reward can accrue to the seller if they surpass a key performance indicator, and vice versa.
Another instance to consider an earn-out is where profitability depends on a critical outcome. The renewal of an important contract would be an example.
If you want to have a chance at getting a good price for your business, consider the combination of excess profits and a willingness to be the lender of last resort.
A willingness to provide vendor finance will increase your pool of buyers. It will put you ahead of the pack.
