Instead of loan financing consider a ROBS

Instead of loan financing consider a ROBS

For prospective buyers in the U.S. with substantial assets lodged in a 401(k), 501 (k), IRA or other retirement fund, Rollovers as Business Start-Ups (ROBS) may provide a means of financing with some very significant advantages.

When we say ‘substantial’, that means a minimum of $50,000 to roll over. Otherwise, the set-up and monthly maintenance costs for the quite complex ROBS arrangement will be too great a proportion of the investment to justify using this scheme.

However, for significant investment amounts the costs are entirely viable and quite advantageous. Set-up fees paid to an experienced ROBS provider are normally around $5000 upfront, with an ongoing annual administration fee of up to $2000. Legally speaking it is actually possible to do all the work yourself, without using a ROBS provider, but that would be foolhardy with many IRS and DOL compliance complexities ready to trip you up.

In fact, the steps are much too complicated to cover comprehensively in an article such as this one. However, here is an introduction to the world of ROBS, what it is and basically how it works.

Age is no barrier

You don’t have to be any particular age to roll-over funds from your eligible tax-deferred retirement account. It doesn’t matter how young or old you are. You just need to have the funds in credit and then work systematically through the rollover process. The great advantage is that this is not a loan at all, so there are no loan fees and no interest to pay. At the end of the day, it’s your money. You are simply accessing it for business investment purposes. The funds cannot be used to service personal expenses or to acquire purely personal assets. ROBS is for business investment only. As one potential source of finance to be considered, it can be used in parallel with other financings, including loans

In essence, you will be rolling over your money from one retirement fund into another new one, which your business will set-up. If you are buying an existing business you will put the necessary structures in place for the roll-over prior to the transfer of the business. The modest set-up costs cannot be covered by the ROBS itself. You need to cover these separately up front.

How does it work?

The first step is creating a C corporation (C-corp). This is obligatory and cannot be circumvented. However, this part is actually very easy and quite inexpensive, although specific details will vary slightly from State to State. The more complex step is then setting up an employee retirement plan, most commonly a new 401(k), for the new entity. At this point, you roll over the amount you have decided on from your existing personal 401(k), 501(k) or IRA into the new corporation’s retirement plan. The plan purchases stock in the C-corp, acquiring a shareholding on behalf of all employees, as will be explained shortly, and that purchase amount is released as your business capital. The ROBS rollover is now completed. There is no loan of any kind involved to repay. Of course, the retirement fund earns its share of the profits for future distribution and takes its share of any hit if the business loses money.

In the next stage the C-corp, of which you are the part-owner and also technically an employee, uses the capitalization from the ROBS to build a new business or buy and develop an existing one. The funds can be used for any normal legitimate business purpose, but not for personal expenses that only you benefit from and not for over-payment to yourself of any inflated management or director fees. In fact, any salary payment to yourself must not come from the rolled-over funds directly but must come only out of operating expenses. As we said, it’s your money – but in return for the release of investment funds, the new C-corp retirement plan retains its shareholding in the business and receives its share of all profits after reasonable expenses. The retirement fund will be a significant or even the major shareholder (depending on what other financing sources were used) and as director, you are required to the best of your ability to operate the company to the financial benefit of the fund and its members. You will be covered by the C-corp retirement plan and profits accrued by the fund will ultimately benefit you when drawn down.

Administration of this complex legal arrangement is demanding and really needs to be outsourced to an expert ROBS provider, although this is not legally mandatory. Ongoing monitoring for IRS and the DOL, and other statutory compliance including managing the annual IRS Form 5500 return is definitely no work for the business operator. However, the fees for this administration are actually minuscule compared to the loan costs on a comparable amount of financing from traditional loan sources.

Remember it’s still a retirement fund

ROBS advantages come with some complexities. One of these is that all employees of your new business have the right to join the C-corp retirement fund which you have set up. Note that you yourself must be classified as an employee managing or directing the business. There is no legal specification of the number of hours you must actively work on the business or how much you may pay yourself from the business operation, except that payments to yourself must be deemed ‘reasonable’. Otherwise, they will be treated as a ROBS prohibited transaction. This means that using a ROBS arrangement may not be quite as suitable for buying businesses with a ‘passivity premium’ because of requiring very little owner presence or investment of time.

All employees of the business will have the right to join the retirement fund and legally must be invited to do so. The ROBS provider routinely oversees this notification as part of the ongoing monitoring of the arrangement. For smaller businesses, this is unlikely to be an issue as the definition of ‘employee’ is quite restrictive. Contract service providers and casual workers are not covered at all. Eligibility varies slightly from State to State but essentially an employee must be at least 21 years of age, have worked for the business for twelve months or longer, and have worked a minimum of 1,000 hours during the preceding year. Processing the employee contributions and employer liabilities under the plan is quite onerous and is best handled through the ROBS advisor. However, many smaller online businesses will actually have few or not even any additional employees.

Winding up a ROBS arrangement

Often people enthusiastically enter into an arrangement in the excitement of a new business venture without working through what the eventual exit will entail. With a standard business loan, with all the associated costs and often punishing interest rates, paying out the loan when the business is eventually sold is very straightforward even if financially penalizing.

By contrast, exiting a ROBS provision is inexpensive but a little more complex. If the business is sold then the C-corp retirement fund as a shareholder receives its due share of the sale price, minus funds required to wind down the business and pay out existing liabilities. The retirement plan is then wound up and its assets distributed proportionally to all employees who have contributions in the fund. As the business owner and director your own closing balance in the fund is simply rolled over into a new or existing personal IRA for your (highly tax-effective) benefit. Essentially, through ROBS you have used your assets in an eligible retirement plan to finance business for as long as you operate the business, maybe for many years. At no point through this arrangement have you taken a loan or drawn down cash, and hopefully the ROBS has saved you lots of money.

However, it would be remiss in this article not to cover the implications of a less positive scenario in which the business makes a loss or even totally folds. Simply put, if the business has lost money and is sold for a lesser value than it was set up or acquired for, then the retirement fund and all of its beneficiaries, including you, take a hit. In the event of a total business failure, the assets you originally held in your original retirement plan will have been wiped; but as the ROBS is not a loan there is no financial liability to repay. Formally unwinding the ROBS must still be done according to law and the C-corp retirement plan is then closed out. Any other employees covered by the plan must have their situation and options explained to them. The ROBS provider would attend to this.

ROBS presents a positive opportunity

The ROBS scheme, while it may sound a bit daunting from the explanation provided above, is actually a very innovative business-backing initiative. It enables entrepreneurs to access money which is locked away in a retirement fund for business ventures, without the burden of normal business loans and with the prospect of strong profit returns on personal investment.

Start-up businesses and online businesses which have been bought and built up using some capital from ROBS arrangements actually have a significantly higher success rate than businesses relying more heavily on business loans for the primary financing. This may possibly be because business buyers who are backed by both retirement fund assets and the sophistication to understand the ROBS provisions are likely to have the capacity and the necessary perseverance to develop financially successful business outcomes.

ROBS arrangements are not for everyone. If you have $50,000 or more locked away in eligible retirement plan assets, make some time to talk to an expert ROBS provider. A substantial one-off first-time advisory consultation is generally offered totally free and without obligation. Be aware that the adviser will have a vested interest in talking up the arrangement, but you can always walk away. It’s a fascinating and potentially highly lucrative financing option to explore.

 

Working through the due diligence process

Working through the due diligence process

Buying an online business is exciting. So exciting that it’s easy to get carried away and risk buying unwisely. The good news is that it’s easy to avoid that pitfall.

When you’re buying an online business, everyone advises you to ‘do the due diligence’. Of course you must, that’s obvious, but exactly how do you do it with an online business acquisition? Unlike real estate or bricks and mortar retail and service businesses, there’s usually very little property, equipment or inventory being acquired with the purchase. You are assessing predominantly non-physical assets – but that doesn’t mean they are too intangible to inspect, assess and value.

Depending on the complexity of the business and the size of the purchase transaction, this stage is likely to take at least two weeks and will probably be the longest part of the overall sale process. Patience and staying grounded in this phase will really pay off in the long run, and if you decide to go ahead with your acquisition then you can do so with the fullest confidence.

Where due diligence fits in

Due diligence is different from the buyer’s initial consideration of the business as an appealing target for acquisition, no matter how carefully that has been done. It is a thorough and methodical analysis.

The due diligence phase commences once you have made a purchase offer in a formal letter of interest and the offer has been accepted in principle by the seller. There will probably be some mutually agreed variations written into the final specific details of the sale contract as a result of what is discovered in the due diligence probing by the buyer.

This is unlikely to be because of any deceptive claims by the business owner. Rather, the buyer may discover some impediment to the transfer of software licensing, other third-party arrangements or credit card processing arrangements, just for example, which need to be addressed in the final Agreement.

Remember that before gaining access to all the details of the business financials and operational systems, including all the external agreements in place and the level of owner expertise and time needing to be invested on a continuing basis, the buyer will need to have paid a substantial deposit or even full settlement amount, as negotiated, which is refundable and held securely in escrow. This is because otherwise some parties claiming to be authentic prospective buyers are merely attempting to gain access to the business financials and processes.

So, now at this stage it’s time to work quickly and efficiently, but still highly systematically, through the due diligence process. Discussed below are the key aspects to consider.

Take qualified advice

If you have lots of experience in the area it will all seem straight-forward and intuitive. On the other hand if this is one of your first acquisitions, overall or in the particular niche, gain the assistance of a more experienced guide who can lead you through the more technical aspects. If this is a trusted colleague then that’s ideal. However, the services of paid buyers’ advocates/consultants are readily available and not all that expensive. Ensure that anyone guiding your due diligence and the decisions based on it have no vested interest in the sale going through. Be wary of advice from brokers who, no matter how ethical, have a vested interest in promoting the value of the business.

Traffic analysis

The seller’s claimed traffic statistics need to be verified. Genuine sellers will readily cooperate in providing access to Google Analytics (or equivalent) over the long term so that the buyer can ascertain how many visitors the site has, how long they stay, what they view and whether they generally view multiple pages. If they stay for a low duration (under one minute) then it may indicate that the content quality or the UX is low. If visitors generally traverse multiple pages then the content quality and the UX is indicated to be high. Check the conversion rates for whatever monetization strategies are in place, and most importantly look for any emerging trends. Cross-check the financials with the traffic. How much revenue is each unique visitor generating on average? Does this outcome correlate with what the business model predicates?

Be alert to the possibility of any paid traffic or sponsored links driving traffic to the business. That is not inherently bad, of course, but it is an expensive strategy and a significant problem if the expense has not been disclosed by the seller. Over-reliance on unsustainable traffic sources is actually the most common single concern encountered by new owners acquiring online businesses.

Financial records

Assessing the audited accounts of income and expenses for as long into the past as possible is essential. Ensure there are no hidden expenses, such as software licenses or other licensing and registration fees. Ascertain the investment of the current owner’s time and expertise and put a dollar amount on this if the owner is not being financially recorded as an ‘employee’ cost. Be highly alert to the costs of all outsourced work such as content writing and website maintenance and ensure these are being fully disclosed. Don’t rely only on previous years’ financial records. Be vigilant about what the income and expenses are right now. Look for any indications of plateauing or even downturn.

Get to know the seller

Your due diligence process can be a dream if you establish a good business relationship with the current owner. That doesn’t mean it will be a nightmare if you don’t, but certainly your due diligence won’t yield all the positive information that it potentially could.

In online business purchases it remains fairly unusual for the buyer to meet the seller or the seller’s agent in person; after all they may well be located worlds apart. However, it is good practice to establish the seller’s business profile, history and reputation. While somewhat subjective, using social media platforms such as LinkedIn provides a valuable means of background checking.  

An authentic seller will be confident in the business and will have genuine reasons for wanting to sell the business at the present time. The current owner will have a clear sense of how the business is performing and, just as importantly, trending. Additionally the vendor may well have ideas for the next stage development of the business which would be useful to the purchaser, even if the buyer decides not to follow that particular growth strategy pathway.

Sellers should always be open to detailed questions from a prospective buyer as a result of the due diligence process. It is sound, and increasingly common, practice for the seller or the seller’s agent to agree to a conference call discussion with the buyer, to respond to questions or concerns raised by the due diligence. It also enables alignment of the buyer’s and seller’s expectations of the transfer. No reasonable seller expects a buyer to part with hard-earned money just on the basis of the buyer’s enthusiasm and blind faith.   

Technical and other asset issues

Successful online businesses all rest on relatively sophisticated technical operations, with not only base platforms but also plugins and extensions. It is essential to audit these and ensure that every element of the platform has been paid for or licensed, and that these are to be transferred with the business. SaaS and software businesses, as well as e-Commerce sites, will be reliant on source codes and it is important to confirm that they are clean and also modifiable for the future.   

Other assets which must be transferred include all domain names, subscription lists, customer records, product images and all third-party contract and communication details.

Owner’s operational commitment

What time and effort commitment is being invested by the current owner and what is the cost value of this? The seller should be open and specific about the details of this investment. Is this within the buyer’s capacity of expertise and time availability to sustain, and if outsourced what will it cost?

Legal aspects

Obviously, it is essential to check that the seller legitimately owns the business, its domain names and the assets being transferred, including all third-party agreements. It is unlikely that a site which is legal and unrestricted in its source territory will be illegal or prohibitively restricted in other territories which the buyer considers targets for growth. However, it is always possible and should be checked.

After the due diligence period and before committing to the final Agreement to purchase, it is important that the purchase contract be checked by a qualified legal practitioner with particular experience in the online business environment.

It is important to ensure that the seller has entered into a non-compete agreement for a specified period of time, and that this agreement is enforceable.  

Final considerations

It’s vital to be ultra-careful that all trademarks, propriety branding and any third-party brand licensing agreements are fully transferring with the business acquisition. Ensure there are no undisclosed debts or unpaid liabilities of any kind. In this regard double-check that you have an overview of the refunds policy and the potential liabilities arising from customer claims and returns once you have assumed ownership.

It is always wise to build into the sale contract a holdback provision. This allows the buyer to retain a percentage of the final sale price, usually 10 to 20 percent, for 30 to 60 days after the transfer. The advantage of this is that unanticipated delayed costs which were not incurred by the new owner can be debited against the final payment. Additionally, the seller will be motivated to assist in the ironing out of any issues in the transition which could not reasonably have been anticipated by the buyer on the information available.

Provided the final payout funds are securely lodged in escrow, a reasonable and ethical seller is unlikely to resist this provision as part of the purchase agreement.

There can never be a 100% guarantee against an unfortunate purchase. However, following these clear due diligence steps will provide very strong protection against disappointment and any possibility of falling victim to deception.

What an SBA loan means for buyers and sellers

What an SBA loan means for buyers and sellers

Accessing finance to buy an online business can be a tricky area. It is essential to evaluate all potential sources of funding including seller financing. While some investors do have cash readily at hand and are just looking for an investment with profitable returns, most buyers certainly have the energy, enthusiasm and ideas to invest but fall well short of having the total funds required. Hence the need for borrowing.

Most mainstream lenders, particularly banks, are reluctant to lend for online businesses. If you are intending to build your own business from scratch, you can basically forget about a bank loan. If you are buying an established online business your chances are only slightly higher. Even where there is audited evidence of financial success over a period of at least two to three years, typically online businesses have very little in the way of saleable physical assets or inventory to provide collateral. Even if the borrower has separate assets such as real estate to mortgage, major banks tend to shy away from lending for online business purchases even if the loan is fully secured. Banks aren’t sentimental, but foreclosing on mortgages is never a good look for them!

So, where to go for a loan?

Perhaps surprisingly the most common loan source for startups and online business purchases still remains family and friends funding. In most cases this comes with some advantages but many drawbacks and limitations. Alternatively there are numerous small business lending providers who are willing to back an online business purchase, but usually at a hefty interest rate and with a relatively limited pay-back period required as part of the contract. Obviously unsecured loans are more expensive than secured loans. While this is always a borrowing option, think carefully before committing to one of these loans as paying it off could be financially draining.

What about an SBA loan?

Depending on your circumstances this could be where an SBA loan comes in. The US Government Small Business Administration loans underwriting program is designed to enable funding of small businesses as an incentive for investment and as an economy growing measure. The SBA program has numerous strands and is designed to meet many different contingencies, including even business loans for disaster recovery. However, in the case of borrowing to purchase an existing online business the relevant scheme is the SBA 7(a) loan.

How does an SBA loan work?

The government does not lend any of the money directly to the borrower. Rather it guarantees the loan, or typically a high proportion of it such as 85%, for the security of the lending institution. Many but not all banks will consider loan applications where the borrower is securing an SBA guarantee. The process is complex and quite arduous for the borrower, so it is vitally important to source in advance a bank or other major lending institution which has plenty of experience with loans underwritten by the SBA and the capacity to provide advice and guidance throughout the application stages.

Because the process is time-consuming, working with a potential lender without an established record in fast-tracking SBA loans will definitely delay the process to an extent which may dissuade the seller from entering into an agreement. Even with an experienced SBA lender the loans process is still likely to take somewhere between 45-90 days. This is very important to understand because a formal letter of intent to purchase and signed Agreement subject to SBA-guaranteed finance must be lodged before the application will be considered.

There are many private SBA loan facilitation specialists who will guide you through the process and connect you with a lender most likely to approve your SBA-guaranteed loan application – but for a fee of course. This cost can significantly erode your net financial position before you even start, so it’s worth investing the time and effort to understand the process so you can work your own way through it.

Eligibility Requirements

These are pretty strict, which is why only a small (but growing) proportion of borrowing for online business purchases comes from this source.  

Technically the borrower does not have to be a US citizen but the business development needs to be considered economically beneficial within the US and any borrower who is a foreign national needs to meet strictly defined residency status conditions.

The qualification requirements are too complex to cover in full here, but in a nutshell the business itself must be:

  • based primarily in the US
  • within the technical definition of a ‘small business’
  • for profit – and demonstrably profitable
  • an existing business, established for at least 2 years, with invested equity.

Any person borrowing for investment in the business must have:

  • an established credit score (at least in the high 600 range)
  • a bankruptcy-free record
  • no criminal history
  • no unpaid debts to any Federal agency
  • demonstrated competence to manage and develop the business proposed for purchase
  • an absolute minimum of 10% deposit after all fees incurred in the acquisition have been accounted for.

Detailed business financials and a clear business plan need to be provided with the application and it must be demonstrated that there is a proven need for an SBA loan. That is to say, other sources of finance are not available or financially viable for the borrower.

Advantages for buyers

Don’t let the seeming complexity of all this put you off. After all, your business success relies on diligence and perseverance! The advantages of an SBA-guaranteed loan are enormous, including minimum personal equity required, favourable interest rates and an extended loan repayment period.

It also provides you with substantial reassurance of the business profitability and development viability if the seller is willing to undertake the degree of financial and business plan scrutiny which the SBA loan process requires.

Implications for sellers

If you are confident of the worth of your business and want to secure the highest possible sale price, and if an ultra-short settlement period isn’t your highest priority, then entering into an agreement with a buyer intending to use an SBA loan may be a win-win outcome. Those buyers with ready cash or access to a rapid funding source will expect a discounted price in return for the certainty of a quick settlement. Cutting out a prospective buyer who is depending on an SBA loan will narrow your field of potential purchasers and may not yield the high sale price you could achieve.

The SBA-guaranteed loans program is a significant source of buyer finance for small businesses. The online business segment is still only a small proportion of these loans. But to provide just a slight indication of the scale here, Wells Fargo’s annual lending in the SBA 7(a) loans field alone is worth around $5 billion. Five billion dollars from just one single SBA lender. That’s a lot of small business investment money to spread around.

So, as online business sales increase, as a seller it’s certainly a good idea to be open to an SBA funded purchase offer.

 

What sellers need to know about valuations

What sellers need to know about valuations

There is no shortage of motivated buyers on the lookout for great online businesses. While the stock market is highly volatile, there is increasing enthusiasm for investment or purchase of online businesses. So, the potential appetite for buying is enormous. However, by far the major brake on buyers committing to a final purchase decision is their uncertainty about pricing. There is little understanding of sound valuation principles and buyers are wary of what they see as pricing based on an arbitrary multiple of net profit. Not to put too fine a point on it, buyers believe that sellers generally over-value their businesses and they find it hard to define a reliable and objective valuation method. The outcome is that too often an enthusiastic and highly motivated buyer fails to follow through with a final purchase because of the understandable anxiety about paying more than the business is worth.

How to value an online business

Typically with an online business, there will be little or no inventory to value and only a very limited if any physical asset base. Accordingly, the business will generally be valued almost entirely on the projected profits, calculated on the basis of current and relatively recent past profits.

While there are various alternative techniques for valuing an online business, including the traffic valuation method for sites with high traffic as a business asset but with no or incomplete monetization, many of these methods are highly technical and yield disputable outcomes. They are often suitable only in highly specific situations, depending on a precise definition of the particular revenue model, current and projected OR you are the next Facebook which is highly unlikely.

For that reason, online businesses are almost always sold on a negotiated value based on an earnings multiple or a price to earnings ratio. While it is very common to define the ratio in terms of a multiple of average net monthly profit, it is simpler for most purposes to quote the ratio as a multiple of annual net profit. Using this basis, average asking price multiples have increased from 2.4 in 2010 to around 3.4 now (sourced from our good friends at Centurica), with final selling prices typically at around a 10% discount to the asking price. This suggests that generally speaking sellers who value their businesses realistically can expect to achieve a sale outcome within reasonable range of the asking price. But putting a realistic value on the business is complex and there is an understandable tendency of business owners to over-value their business.

The average net profit multiple varies markedly from one kind of online business to another and also depends greatly on the specific market niche. However, the absence of highly consistent profit ratios can cause buyers to be both surprised and sceptical about the valuation proposed by a vendor. On objective grounds SaaS and e-commerce businesses sell for a significantly higher profit multiple than content-based or media businesses, because of the higher reliability of recurring income in the former models and the generally much higher operational time demands in the latter cases.

As an example, a currently listed relatively small SaaS business (not on Flippa) with a claimed $55k net annual profit has an asking price of $250k, a hefty earnings multiple of 4.55. You would expect that ratio level to make any buyer hesitate. Let’s assume it doesn’t have rocket ship growth (doubtful because they are selling) a buyer simply will not pay that amount.

Vendors who are seeking to sell at an earnings multiple above the prevailing average need to factor in the understandable buyer nervousness and be sure that the audited income and expenses figures are going to stand up to serious interrogation. While there is never an absolutely guaranteed success in any investment decision very few buyers overall, and virtually none in the six and seven figure range, are interested in taking a wild gamble on getting value for money.

The valuation factors that buyers will weigh up

Because it goes without saying that buyers generally regard sellers’ asking prices as inflated, it’s important that the vendor has realistically priced the business having regard to all the considerations which the prospective buyer will be factoring in.

The income figures must be accurate and cover the duration of the business operation, including only those income streams which will fully transfer to the new owner with the sale. Gross and net income trends will be crucial to the buyer’s assessment. All expenses must be transparently declared in detail, including all payments made to service providers and suppliers of goods and expertise. It is vital to new owners that they will be able to maintain all of the necessary business operations within the same cost structure, or ideally achieve some savings where possible. Any outstanding expenses or other debts transferring with the business obviously must be declared.

Absolutely all operating expenses need to be disclosed, not disguised, by the seller and discoverable by the buyer. Often overlooked, the full value of any unpaid work which has been invested in the operation of the business will be accounted for in the buyer’s own valuation of the business. The predicted cost of the new owner’s time, and any specific technical expertise required, will significantly affect the buyer’s business valuation. It is absolutely essential to the prospective buyer to be able to rely on an honest declaration of the time and expertise required to manage the business, as the new owner will need to put a dollar value on this expense.

The prospective buyer will need to analyse all the financial indicator trends over the longest time frame for which the figures can be produced. Sources of customers and the cost of gaining them will be important factors for the buyer, as will the effects of any changes to attracting traffic such as Google algorithm changes or even penalties which may affect search traffic.

The buyer will need to assess how competitive the niche is and whether there are barriers to the entry of competitors, which raise the business valuation, or the likelihood of increased competition in the absence of any significant barriers to entry, which will lower the valuation. It is crucial to the buyer to ensure that any licences required are fully transferable, or readily obtainable by the new owner, and that any branding, trademarks or other unique advantages will transfer with the sale.

The seller needs to appraise the business through a buyer’s eyes

The seller will be keenly aware of the time, energy, money and vision which has brought the business to its current status and positioned it for a successful sale. Naturally the vendor wants to achieve the highest possible price. However, seller over-valuation is the prospective buyer’s biggest turn-off. It really enables the sale process if the current owner evaluates the business using the same valuation indicators that the buyer will be applying.

It is worth mentioning that some buyers will apply a discounted cash flow (DCF) measure in their valuation. This is a somewhat less relevant consideration in an era of low inflation as at present, but put simply the principle is that a dollar of profit now is worth more than a dollar will be in the future, so a formula is applied to compensate by lowering the notional future profit value, given that the buyer will be paying in advance the equivalent of some years of projected net profit.

The bottom line for the buyer is that the online business acquisition must be fully transferable, it must be sustainable, it must have scalability, and above all it must be purchased at a reasonable earnings multiple. While it is still relatively unusual for an online business to be bought using funds from an institutional lending source, lenders may place a ceiling on the multiple, determined by the actual business model and specific market niche.

Overall, to achieve a reasonable pool of potential buyers interested in undertaking onerous due diligence and finally negotiating a fair sale price, sellers need to keep their initial asking price close to buyer expectations. Avoid ambit claims with the view that eventually you will negotiate down. The process of carefully considering a purchase is time-consuming for the prospective buyer. The factors outlined above will determine where the buyer expectation sits in terms of an earnings multiple. There are so many variations in play that the ratios will vary between around 2 and 4. There would have to be exceptional circumstances taking a selling price outside this already wide range.

Know exactly why you have decided on your own seller valuation, and understand what the buyer will be factoring in. Your initial asking price should not be more than 10% higher than you believe on reasonable grounds the buyer will consider fair after all due diligence and consideration of all the factors covered here.

It is very clear that a reasonable seller valuation is always the key to a successful sale.

 

Why seller financing makes sense

Why seller financing makes sense

Why Seller Financing might make sense for you when selling your business

Many buyers of businesses are looking to invest in businesses which they can afford to purchase outright, even if this involves short-term Earn-out agreements, which typically are not arranged primarily for finance shortfall reasons. (The many advantages of Earn-outs are covered in a recent Flippa Blog article). However many of those looking to build a portfolio of businesses or to acquire a seriously high-value business may need to source finance.

Traditional business loans from banks and other major lenders are difficult to obtain for business investment. Currently banks are highly risk-averse and even when lending for more conventional business purchases they will be restricting lending to home equity based loans. Amazingly, after all these years of online business progress, the major banks still tend to be out of their lending comfort zones in the business website world, not really understanding or being confident about the way it operates. One of their main reasons for securing the loan with home equity is that banks cannot secure the loan against the physical assets of an online business and they are reluctant to place a value on ‘goodwill’ or business profitability potential.

We’ll cover SBA loans in a future blog post where the situation is entirely different again.

Unsecured loans from small business loan specialists, including online lenders, are more readily available but generally come with unattractively high interest rates and often quite burdening fee structures. Private equity firms which finance online business acquisitions tend to be interested only at high-value levels, and with lots of strings attached including an intrusive degree of business control or oversight.

Why you should consider seller financing

Whether you are a buyer or a seller, give serious thought to the mutual benefits of vendor financing. As a seller, if you are definitely in need of the full purchase amount immediately then of course this arrangement is out of the question. However, you will greatly increase the pool of potential buyers and the purchase price achieved if you are able to offer vendor finance for an agreed proportion of the purchase price. Unlike an Earn-out agreement which is usually limited to a minor proportion of the cost of purchase, does not entail interest payments, and is generally paid out in full within an agreed number of months, seller finance funds a proportion of the purchase with a longer-term payout period and with interest charged on the remaining balance until final settlement.

To illustrate, the owner of the business (owned outright and with no existing mortgages or liens attaching to the business) agrees to a sale price of $100,000. The buyer who has only $40,000 available as deposit, after judiciously retaining sufficient funds for immediate operating expenses and contingencies, has been enticed to pay a premium price because of the availability of seller finance. A reasonable interest rate to be applied to the outstanding monthly balance is agreed and a repayment period of typically around 5 years is determined.

The interest rate can be fixed, or floating and indexed to the official rate. In reasonable fairness to both parties, because the loan remains essentially unsecured the rate is initially set commensurately higher than major bank lending rates for business loans. In the simple illustration above, given the current interest rates and the buyer paying the seller a monthly instalment of $1000 plus the applicable monthly interest, the vendor would receive an income stream averaging around $15,000 annually for the five years. The bottom line for a seller who is in a position to defer full settlement is effectively a significantly higher final sale price, while the buyer is able to afford an acquisition which otherwise would have been out of reach.

It goes without saying that a legally binding contract is necessary for this kind of vendor financing arrangement, whereas Earn-out agreements typically rely on a less formal memorandum unless they are particularly complex or involve six or seven figure sums.

The mutual advantages of seller finance

While for the buyer the obvious advantage as already stated is the capacity to access an business business purchase which could not be afforded if the entire amount was required up-front, there is an additional benefit in the continued interest of the seller in the success of the business. Further, the willingness to provide vendor finance confirms the seller’s confidence in the business model and its ongoing viability and profitability.

For the seller, provided access to 100% of the funds from the sale is not required immediately for other purposes, then the regular income stream with an interest rate which is fair and reasonable but actually quite favourable to the seller is a great advantage and effectively raises the actual sale price achieved. Because the pool of prospective buyers has been increased by the availability of vendor financing, the agreed purchase price is more likely to be at a premium level also. Additionally in some circumstances, there may also be taxation advantages in the delayed payment of the full sale proceeds; this is a complex matter and as a seller you will need professional tax advice on this aspect, but it’s something further to consider.

A win-win solution to a business purchase arrangement

While this will not suit all sellers or buyers, seller finance is certainly an option which should be considered. In fact, it’s such a mutually beneficial situation that a rapidly increasing proportion of online business acquisitions are now financed on this way. For most vendors, offering seller finance is a sure-fire way to seal a deal.

Overall 2019 is emerging as a highly promising year for business investment, and we can expect to see exponential growth in seller financing arrangements.