Business Sales - Payment Structures and Payment Options
When a business or its assets are sold, payment can be made and received generally in five ways. Three ways are very common and fairly obvious, and two are not so common. The three common ways are:
1. All cash with no financing,
2. All cash subject to the buyer obtaining an SBA loan, and
3. A cash down payment with seller financing.
The other two methods are the subject of this article. They are similar to each other, but not identical. They are often combined with one of the more common methods. These include:
4. A base price with an earn-out provision, or
5. Payments based directly on revenue as it is earned.
Each method has its own tax ramifications which is not the subject of this article. What is an earnout provision and when are they most commonly utilized? An example: Assume John is a seller and Mark is a buyer negotiating the price of a business. Assume the revenue of the business has been increasing every month for the last 12 months. Assume the annual revenue is currently $1,000,000, but if the trend of sales continue, it will be $1,200,000 in one year. The seller, John, wants the sales price of the business to be based on revenue of $1,200,000 arguing that it is almost guaranteed to be $1,200,000 within one year and it will continue to increase thereafter. The Buyer, Mark, wants the sales price of the business to be based on the existing revenue of $1,000,000, He argues that increases are not automatic and will be achieved only as a result of his hard work, and may never be achieved. The compromise is an earnout provision in the purchase contract. The parties agree that if revenue increases by a defined amount within a defined period of time, for any reason, the buyer will pay additional money to the seller. The earnout provision may be structured as a one time calculation, or it may be structured with two or more steps. Earnouts are utilized when the revenue of a business has been increasing significantly over time. An experienced business broker can assist the parties in creating a formula that is fair to both the buyer and seller of the business.
Another method of payment for the sale of business assets, is for payments to be made over time based upon the amount of revenue actually received by the buyer. Again, an example will be helpful: Assume John, the seller, is selling a property management business to Mark. Assume there are 50 management accounts with an average monthly fee of $2,000 or revenue of $100,000 per month. Assume there are 5 property managers, each managing 10 accounts. The buyer points out that after the sale, if he loses 3 accounts, his revenue declines $6,000 per month, but salaries, rent, and utilities stay the same. This is a risk that the buyer must factor into the price offered. The seller's position is that none of the accounts should be lost as a result of a sale, but acknowledges that all 50 accounts include a 60 day termination provision. The parties structure the sale based upon the buyer paying the seller a fixed percentage of the management fees actually received each month for a defined period of time, possibly for the entire period of time the accounts are serviced by the buyer. This structure reduces the risk to the buyer and justifies the payment of a far higher price to the seller than any other formula. In one recent transaction, a buyer agreed pay the seller of a property management company, 20% of the base fees actually collected from the sold accounts for up to 15 years. Both the buyer and seller were highly pleased with the structure. Given that the seller was 70 years old, he created a payment stream that made his retirement very comfortable financially.