Selling a business in high interest rate environment
For many of our clients, the valuing of their business is the first and one of the most important considerations when preparing for sale. In addition to analyzing the company’s finances, operations and industry sector, the new owner’s cash flow must also be taken into account.
Why is this important to the Seller of the business? Well, because most Buyers typically rely on either SBA and/or bank financing, the projections must demonstrate sufficient cash flow to qualify for a loan. The loan payments for that business, (along with other costs, like labor, materials, etc.) affect that cash flow. SBA business loans require a Debt Service Coverage Ratio (DSCR) of 1.25. This ratio is calculated by dividing a company’s net operating income by its annual debt service.
Example - $250,000 Net Operating Profit / $150,000 Annual Debt Service = 1.67
In the last year, the Federal Reserve has increased interest rates by 5.25%, resulting in an increase in borrowing costs and a decrease in this ratio. Translation: With SBA rates now at 10.5% or higher, many deals that used to surpass that ratio, no longer do. Not a good situation for an owner who wants or needs to sell or a buyer who really wants to buy a business. However, until inflation decreases or the economy declines, rates will almost certainly not go down.
Owner Financing: A Mutually Beneficial Option
One answer to the challenges created by higher interest rates is the concept of Seller Financing. Most of our clients have some opinions on whether they DO or DO NOT want offer this as an option when selling. While this may not be advisable in every situation, more and more Sellers who are serious about getting their business sold are moving towards this as an option.
Benefits for sellers:
- Attract more buyers by offering owner financing, as rates are lower than SBA’s
- Sell the business faster by eliminating the time-consuming process of obtaining a loan from a bank.
- Command a higher selling price, as buyers are often willing to pay more for a business that they can finance directly with the seller.
- Generate a steady stream of income from the regular payments received from the buyer.
- Potentially spread out the tax burden of the sale over several years.
- Purchase agreements can provide protection and recourse for sellers should loan not be repaid as agreed.
Benefits for buyers:
- Qualify for financing more easily, as the seller is more likely to be flexible with the terms of the loan.
- Obtain loan approval faster, as the seller does not need to go through the same underwriting process as a bank.
- Secure a smaller down payment, as owner financing often requires a smaller down payment than a traditional loan.
- Negotiate more flexible loan terms with the seller, such as a lower interest rate or a longer repayment period.
Overall, owner financing can be a mutually beneficial arrangement for both buyers and sellers alike. However, it is important to carefully consider all of the pros and cons before deciding whether or not to use owner financing in a business sale.
- Owner financing should not be used to exploit or harm buyers or sellers.
- All parties involved in an owner financing agreement should act in good faith and with transparency.
- The loan agreement should be in writing and should clearly outline all of the terms of the loan, including the interest rate, down payment, and repayment schedule.
- Both buyers and sellers should seek legal advice before signing an owner financing agreement.
When Seller Financing is offered as a component to a bank-financed transaction, the DSCR increases, making the deal eligible for SBA financing and more attractive to investors/partners.
While this may not be the right option for every business owner, it is certainly worth a conversation. Have questions? We can help. Call us today 207.835.4770
Another great resource on the do’s and don’ts of seller financing can be found - here
Written by Justin Cotta Holmes, Transworld Business Advisors of Maine Find other articles here TBA Blog