So you want to buy a business and you’re not sure how to pay for it. There are a number of ways to pay for a new business, but the most common are cash at closing, seller financing in the form of deferred cash payments or promissory notes, securities issued by the purchaser, and contingent payments. Contingent payments aren’t so much a form of payment as much as a means of determining the final price of the business assets, but I’ll throw it into the mix because if you’re wondering how to pay for a business, you might want to consider negotiating contingent payments.
Cash at closing
Cash at closing is the simplest form of payment. Sometimes the buyer has cash available without the need for financing, but the cash is often obtained via a bank loan taken out for purposes of funding the acquisition and possibly mezzanine financing provided as a junior loan to the bank loan. The bank generally secures its loan with a blanket lien on all of the assets of the acquired business, and the loan agreement often contains covenants that restrict the buyer’s business operations in some ways.
Banks generally require their customers to have all their corporate minute books and legal relationships in order. This forced discipline is probably a bit of a burden to the business owners who have to spend time and money on such things, but it does help clean up the company’s legal affairs. In addition, the bank will probably review the purchase agreement and make sure due diligence is performed adequately.
SBA loans are often used to finance business acquisitions. For information to help you decide whether an SBA loan might be a good option for you, see my post SBA 7(a) Loans for Buying a Business, which discusses pros and cons of SBA financing.
Seller financing
Another source of funds for buying a business comes from seller financing. Sometimes the seller financing will merely be in the form of deferred payments of the purchase price per the terms of the purchase agreement. Other times the buyer will issue a promissory note in favor of the seller to evidence the purchaser’s indebtedness. In either case, the seller will often require a lien on the transferred assets or stock — and possibly a personal guarantee from the buyer — to secure the debt.
Seller financing obligations are often used as a source of funds for post-closing liabilities of sellers in favor of buyers. For example, if the buyer is assessed for the seller’s unpaid state tax liabilities, the buyer might be able to deduct an off-setting amount from its future payments to the seller. This makes it easier for the buyer to ensure that there is a source of funds for such liabilities as an alternative to an escrow fund.
An advantage of deferred payments to the seller is the possible availability of installment tax treatment of the payments. This enables the seller to recognize income from the sale of the business in the year in which payment is received instead of taking all of the income in the taxable year in which the sale occurs, which can result in lower taxes.
Equity securities issued by the buyer
“Corporate” buyers might pay all or a portion of the purchase price with equity securities, generally shares of the buyer’s stock (or membership interests if the buyer is a limited liability company). This might allow the transaction to be characterized as a nontaxable reorganization. Because the buyer is issuing securities, the requirements of federal and state securities laws must be observed. (This is also true in the case of issuance of debt securities such as promissory notes.)
Contingent consideration
Sometimes a portion of deferred consideration is contingent upon the future performance of the acquired business. The most common form of contingent consideration is an earnout. The earnout might be a fixed amount that is paid if the applicable performance metrics are met, or the amount of the earnout paid might also be dependent on the performance.
I personally saw an increase in the use of earnouts in transactions immediately after the on-set of the recession in late 2008 as buyers and sellers had trouble coming to agreement on price in a falling market. Sellers tended to feel that the recent declines in financial performance were temporary, while buyers were more pessimistic. By making a portion of the purchase price contingent on future performance through an earnout, the parties were sometimes able to come to an agreement on price. If the sellers were correct that the downturn in performance was temporary, they would be paid the earnout. On the other hand, if the buyers were correct, the contingent consideration was not paid.
Buyers of businesses have many options for paying for their new business. What works best for you depends on your resources, as well as the desires of the seller.
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[This post was first published as Buying a Business: How to Pay for It.]