Financing an Accounting Practice
It is important from the beginning to recognize the way that purchasing a practice does not happen. The buyer does not take the full purchase price out of savings and write a check to the seller. If a buyer has that much money, he or she would not be buying himself/herself a job.
Our hope is that the buyer can come up with a substantial down payment. That varies, of course, but owners ofter consider 20%-50% to be adequate. It should be remembered that the down payment is not the only cash that the buyer will be investing into the business. He or she will need working capital to get the new business going and to pay bills until the receivables get up to a normal level and start to turn. So sellers should not be so shocked with the thought that a buyer can manage only twenty percent down. Think back over the years about your clients and ask yourself how many of those clients could come up with that kind of money. When I think of my tax practice, I remember that a client who has substantial interest income was a rarity.
The down payment accomplishes two important goals. First, it shifts a very significant amount of the risk to the buyer. In order to correctly understand investment risk, one needs to think of risk in terms of layers rather than in total. If a person were to buy a piece of real estate for $100,000, he or she might think the risk incurred is $100,000. More correctly, he or she is making 100 investments in the amount of $1,000 each. The first $1,000 invested carries a very significant risk. If the value of the investment declines by a mere 1%, he or she has lost that $1,000 in its entirety. On the other hand the last is $1,000 is not at risk at all. It is as safe as a treasury bill. The real estate will not become entirely worthless.
As an example, when a buyer makes a down payment of 20% and additionally invests 10% in working capital (with the practice assets including accounts receivable being pledged to the lender) then virtually all of the risk of the practice ownership is transferred to the buyer rather than the lender. The value of the practice would have to decline by more than 30% before the lender is at risk at all. This is possible, but unlikely. In twenty-one years of practice ownership, I never saw my gross revenues decline by more than ten percent.
The second thing that is accomplished by the down payment is that it gets the buyer committed to the purchase. Buyers will go to great lengths to avoid losing this very substantial investment. Oftentimes, unsophisticated lenders (such as the seller) imagine that at the first sign of difficulty that the buyer will walk away from the practice and leave him holding the bag. Nothing like this is likely. The buyer might find that the practice does not meet all of his dreams or expectations. He might find that he has to work at it a lot more than he realized, but he has too much invested to walk away. Sophisticated lenders realize that if you have a buyer who can make a substantial down payment that you have eliminated the vast majority of the general public and are working with a rather unique individual. If this person additionally has a history of handling his credit in a responsible manner evidenced by this credit report and the fact that he has accumulated a substantial net worth, then the lender knows that his risk is minimal. When the going gets tough, the buyer will step up to the plate and find a way to make the investment work or else he will sale the practice in such a way as to preserve his good credit and to recoup as much of his investment as possible. The lender can sleep in peace.
While buyers do not normally have enough cash to pay sellers all cash at closing, it is still possible in many cases for sellers to get substantially all cash for their practices. The primary source of this cash is through SBA financing. Normally conventional financing is very difficult due to banks insistence on collateral lending. SBA, on the other hand, is willing to loan based primarily on the historical cash flow of the business, the buyer’s credit history and the buyer’s experience. In addition, interest rates on an SBA loan are reasonable (while variable), and a ten year term allows for low payments. The downside of SBA financing is the bureaucratic process of application and approval and the upfront fees.
The first problem, however, is that it is harder to qualify the practice than it is to qualify the buyer. In order to qualify the practice, the cash flow from the practice has to cover 125% of the total of the new owner’s salary and his debt payments. The owner’s salary needs will vary depending on his other (spouse) sources of income and his obligations. Your practice will have to have more cash flow to qualify for some buyers than for others.
From our experience, half or more of the practices do not have that much cash flow. Do not blame the buyer for this. If your practice is bigger than minimal size and if your net cash flow is somewhere near fifty percent of gross revenues then it probably will qualify. If historical cash flow is significantly less than fifty percent of cash flow, you need to face the fact that the profitability of your practice is not up to ideal and that your practice may not qualify for SBA financing.
What we hope for in that case is that your cash flow will pay the owner’s salary and make debt service or that your buyer has sufficient expertise and determination to fairly rapidly expand profitability. In these cases, seller financing should be considered. Besides the fact that seller financing might be the only practical way to get a practice sold, seller financing also carries a couple of benefits. For one, it is a fact of life that a practice can be sold for ten to fifteen percent more with seller financing than without. In addition, there are additional advantages to the seller related to installment sale treatment for tax purposes and possibly a desirable rate of interest earned on the loan vs. CD rates. Besides these advantages, a seller financed transaction avoids a great deal of time consuming SBA process and allows deals to get done that otherwise would be impossible.
At Accounting Practice Sales, it is our goal to a sell practice for all cash or cash equivalent. What we mean by cash equivalent is that even if the seller does finance the sale, he should sleep at night the same as if he has all cash. We do not believe that the seller should be at risk for the buyer’s success. If the payment of the remaining purchase price is dependent on the buyer making a success of the practice, then the seller is still at risk. To avoid this, the practice can only be sold to qualified buyers whose net worth, credit history, down payment are substantial enough so that the seller will be paid even if the buyer does not make the practice as much of a success as he has hoped.
It is our very strong recommendation that sellers maintain an open mind about some amount of seller financing. This can result in an easier sale and a sale at a better price. If handled correctly, this does not have to increase seller risk. We encourage sellers to withhold judgment until they have actually met the potential buyer. We will obtain credit history and personal financial statements. We will consult with you regarding down payment and structure of the loan. There are some buyers that you should not finance and some that you should. Until we know the details related to the individual case, you should maintain an open mind. Our goal is to structure a deal that is cash equivalent. We will continue working with buyers until we find a way to do that. To get to that goal, we might have to find other collateral, larger down payment, or other forms of assurance. In some cases, it might mean finding a different buyer.
While everyone has heard horror stories of sellers having to take back a business that is sold, this is extremely rare in instances where the transaction is handled by a professional business broker. Owners who sell their practices by themselves often have only a limited number of buyers to work with and often force a deal by accepting too little of a down payment and otherwise failing to qualify the buyers. Often these sellers are so desperate to find a buyer that they will finance an employee with nothing or little down who lacks the skills to run the business successfully. On the other hand, we make sure that we find a qualified buyer, obtain sufficient down payments to insure the buyer’s commitment and otherwise structure the deal so that it is not dependent on the buyer’s subsequent experience with the practice. Additionally, sales handled by business brokers seldom go back to the seller because the buyer knows a broker and will generally use this avenue to re-sale the business and pay off the buyer, rather than sit by helplessly and watch it decline.