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Do You Plan To Sell A Business To Buy Another Business?

Brooklyn Bridge from one business to another

Prepare Yourself And Hire The Right Team

By Robert Duplicki      Updated March 20, 2023

Selling a business to help you buy another business might make sense as part of your long-term strategy. Using seller financing to help you finance each transaction could be the answer you are looking for.

A Google search for “both a borrower and a lender be” produces 5870 results. Pretty small compared to many other searches. And perhaps often, not the best advice. But this is a concept often used by the wealthy, as they use “other people’s money” to invest and operate businesses. The same people will lend money for a higher return on their investment. Or they may use seller financing to help sell a property or a business.

In an informative article on the International Business Brokers website titled “Benefits of Structuring Small Business Transactions,”[2] Michael Fekkes states “It is rare for a privately-held business to change hands for an all-cash price. More common in small business sales would be to have a component of seller financing as part of the deal structure.”

As you work through this process, of course you should utilize professionals such as attorneys, accountants and business brokers. But it’s been said before that attorneys are deal killers. Use of tools such as seller financing and simultaneous closings are often associated with real estate investors, and referred to as creative financing. The common thread with business owners is the entrepreneurial spirit. So an attorney properly doing his job, may advise you of the risks inherent in certain business approaches. This will be enough to scare some people away, and rightly so as each transaction stands on its own. Yet as an entrepreneur you will have a sense when a good deal is worth the risk. Being properly prepared on your own, will help you structure a deal in conjunction with the professional advice you receive.

Speaking of preparation, if you are going to sell a business to help you buy another business, please read my article "Seller Finance Your Business In 2023". This will give you necessary background before continuing the current article. Topics include:

  • Advantages For Business Sellers
  • Advantages For Business Buyers
  • Action Step (Learn more about business notes)
  • Installment Sales
  • Seller Financing And 1031 Exchanges
  • Is The Potential Buyer Of Your Business Considering An SBA Loan?
  • Conclusion

Additional references are provided.

Selling a business can be a challenging experience for the business owner. A typical time frame to sell a business is one year plus or minus. And you want to buy another business. There is a lot to learn, and you are doing this while running your current business. The process is time consuming and has its emotional aspects. You may have heard a little about seller financing, and aren’t comfortable with the idea. There may be a need and/or expectations to stay involved with your existing business after the sale. I think it will help if you can get excited about the entire process.

Once you have decided to sell your business, and buy another business, you need to develop a comprehensive plan that will help you manage the process from start to finish. This will probably evolve along the way. For starters, what do you need to learn? Then consider assembling your dream team of professionals. Make sure everyone understands what you expect so there is no duplication of services.

No matter how your transactions are financed, you will need to determine the value of the business you are selling and the business you are buying. To get started here are a couple online resources that include free and low cost options:

These resources will at least give you input that you should consider.

How Will Selling My Business Help Provide The Financing I Need To Buy A Business?

Let’s start with some basic concepts:

  1. The down payment you receive can be used to pay part of or the full down payment of the business you buy.
  2. The down payment you receive can be used to pay part of or the full down payment of a property you will purchase to operate your new business.
  3. If you provided seller financing, the payments you receive can be used toward seller financed payments for your new business or associated real estate.
  4. Of Course any surplus from the down payment or installment payments you receive, can be used for personal property and expenses related to your new business.
  5. If you provided seller financing to sell your business, the note you are holding can be sold in whole or in part, and the proceeds can be used however you choose toward your new business.
  6. If you sold real property when you sold your business, you may be able to do a 1031 Exchange for newly acquired property to be used in your new business. This partly depends on the timing of the two transactions. More information can be found in my article Real Estate Notes
  7. When you sell your business if you include an earnout provision [3] or a consulting agreement, the proceeds can be used however you choose toward your new business.

Looking at these concepts above, you will notice that by providing seller financing to sell your existing business, you receive more options to facilitate the purchase and operation of your new business. So this follows what I’ve written before about using seller financing to sell your business. The process gives you more tools to facilitate both buying and selling. And a big advantage is added flexibility. If you spend some time thinking about this point, taking into account the ideas in this article and the others mentioned, you will discover added flexibility for your own situation.

The other side of the coin from added flexibility might be the limiting viewpoints you find from various resources. You may read an article about seller financing or owner financing that quotes an industry source, such as a real estate agent or mortgage broker. They will comment on the same aspect of the process, and one person will have a negative viewpoint, the other positive. Neither article will offer enough background to properly evaluate these comments.

Personal experience of differing professionals can be enough to render opposing opinions. And neither person may have adequate background to be considered an expert on the topic. If you hear or read the word “typically,” remember that may not really be true much of the time.

TECHNIQUES THAT FAIL FOR ONE MAY BE PERFECT FOR ANOTHER

Seller Financing Ideas That Will Help You Buy Your Next Business

I just mentioned the added flexibility that seller financing offers. By staying mindful of these possibilities throughout your dealings, you can utilize flexibility in your situation. Whether it be when you are learning concepts, negotiating with a buyer or seller, or discussing matters with your advisors, keep thinking of creative ways to structure your deals.

Interest Rates

For example, you offer $1,000,000 to purchase a business with a $300,000 down payment, and the seller holding a business note for $700,000 at 9% interest for 120 months. The monthly payment would be $8,867.30. The seller wants $1,100,000 for the business. What are your options to make a deal? There are many that may or may not work. You could counter at $1,100,000 with $300,000 down and the seller holding a note for $800,000 at 5.96% interest for 120 months. The monthly payment would still be $8,867.30. The seller gets her price, and you keep your down payment the same while maintaining the same monthly payment. Either business note if sold at the same time has equal value.

In a seller financed transaction, the interest rate is negotiable. A note with a lower interest rate if sold, will have a lower value, all other factors being equal. In the example above, the change in other terms balances the value of the two business notes.

How Low Can Interest Rates Go?

Zero interest is possible. Even during times when market interest rates are higher than average, zero interest has been used. While there are situations where this makes sense, you should be aware of imputed interest.

Imputed interest refers to federal taxes applicable to interest income. The IRS requires that taxes be paid on interest income as if a market rate of interest was charged. This approach also applies to deferred interest bonds such as zero-coupon bonds.

The specific source of the rates used is the table of Applicable Federal Rate(AFR), published monthly by the IRS. You can get this information at apps.irs.gov/app/picklist/list/federalRates.html.[4] There are five tables based on the applicable tax code, and rates are grouped by short-term (less than 3 years); mid-term (3-9 years); and long-term (greater than 9 years).

For example, let’s say you make a loan of $1,000,000 at 1% interest, and the applicable AFR is 2%. If you are paid $10,000 in interest annually, on your tax return you will need to show $20,000 interest received, and pay taxes accordingly.

More About Interest Rates
  • If you might sell your business note, the interest rate should be set at least 3% above the prime rate.[5] Higher interest rates will help note buyers purchase your note at a lower discount. Interest only monthly payments are discouraged.
  • As pointed out earlier, lower interest rates can be balanced by other factors that make your business note more attractive to note buyers.
  • Following up on the section above, a low interest rate or even 0% interest is not out of the question. It depends on the motivation level of the seller, the other numbers making up the deal, and the buyer’s ability to make monthly payments. By including this possibility in a pre-deal conversation with your accountant, you should minimize concerns about imputed interest and other tax matters.
  • As the seller or buyer of a business, would it help you put a deal together if no interest was charged for six months?
  • Stepped payments may be an ideal alternative. Pick a lower interest rate to start. Increase it by one percent in years two and three and four. In year four make the remaining term fully amortized. The details depend on what works best for the seller and the buyer. More information can be found at What's Better, A Balloon Note Or Stepped Payments?
Other Factors To Put A Deal Together
  • Down payments are a necessary component of purchasing a business or commercial property. Even the “nothing down” concept refers to putting none of the purchaser’s money down. Some other source is used for the down payment. But down payments are another opportunity to be creative. In seller financing the down payment can be adjusted to make the numbers work for buyer and seller.

    For a business note to be sellable, the cash down payment should be 20% or more, from the buyer’s own funds. Most note buyers prefer that the down payment be at least 30%.

  • The term of a business note or a real estate note will change the value of the note if you sell it. The longer the term the lower the value, all other factors being equal. To make selling the property and the note work favorably, a business note amortized over a longer term with a seven year balloon could be the solution. But a seven year term without a balloon is probably better for the seller.
  • A short term note will also not be looked at favorably if you try to sell the note. For example, a note with a two year balloon payment. The concern is the potential difficulty to refinance the note in a short time span, in order to pay off the balloon.
  • If you are using seller financing as a seller or a buyer of a business, and real estate is also involved, create separate business notes and real estate notes, if a note may be sold in the future.
  • As you sell a business to help you buy another business, bank financing could be part of either transaction. Will a bank allow you or your buyer to set the interest rate, the amount of the down payment or the term of the loan? How will bank or SBA standby requirements impact the buyer and or seller? What other bank requirements, procedures, fees and contractual language will have a negative impact on buyer or seller? How will the tax advantages of an installment sale compare with bank financing? How will bank financing work in conjunction with seller financing?
  • As you think of creative ways to structure your deals consider all the components as part of a formula to make a deal that works for buyer and seller.
  • This list isn’t meant to be all inclusive. To do so really includes all the other resources I have mentioned, along with any factors that are unique to a particular deal.

Even though the word "loan" is often used in reference to seller financing, money is not actually being loaned. As confirmed by the Congressional Research Service, "...an installment sale is the exchange of the seller's property for the buyer's promise to pay at a later date."

One More Idea

Let’s say you sold your business for all cash. Do you want to invest all the cash in your next business? Or could you get a better return on a real estate investment? If you are using bank financing to purchase your next business, but need more funds, securing a seller second position note could be ideal. The seller might be reluctant to do so. Perhaps the seller would be willing after learning about the tax benefits of an installment sale. On the other hand, the seller could be highly motivated to sell, and providing a seller second note would help you preserve some cash.


Thank you for reading this article. If you ever have a note for sale, please complete one of my worksheets so I can get to work for you. Whether it's a business note or any other kind, I look forward to producing a solution for you.



References

  1. Photo by Hannes Richter on Unsplash.
  2. International Business Brokers Association (IBBA), "Benefits of Structuring Small Business Transactions," by Michael Fekkes, November 2015, https://www.ibba.org/articles/benefits-of-structuring-small-business-transactions.
  3. Investopedia, Business Essentials, explanation of "Earnout," https://www.investopedia.com/terms/e/earnout.asp.
  4. IRS, Applicable Federal Rate(AFR), apps.irs.gov/app/picklist/list/federalRates.html.
  5. Wikipedia, historical table of Wall Street Journal Prime Rate, https://en.wikipedia.org/wiki/Wall_Street_Journal_prime_rate.

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