Financing the External Acquisition
Overview: Solo advisors should understand the pros and cons of the typical methods used
to finance the sale of a practice. Knowing in advance your options, will help to negotiate a funding package that maximizes the net value of the transaction.
Prior to discussing the fundamentals of financing an external acquisition, it is important to lay the groundwork by first examining an important consideration that will help decide on the structure of the deal. Should the acquisition be structured as a stock sale or an asset sale?
For those advisors who operate as sole proprietorships and who are selling their business’s property, the transaction is always considered an asset sale. Since there is no business entity established, the sole proprietor does not have the choice of selling stock or LLC membership interest. Therefore, they may be restricted to selling only the assets of the business and not the entire business itself. This isn’t necessarily bad as long as the selling advisor understands that they will not have access to certain succession strategies that are based on selling the entire framework and assets of the business.
For example, certain incentive-based internal succession strategies allow an owner to arrange a slow departure over time by selling portions of their stock to a successor. These strategies allow the owner to stay the majority shareholder and therefore in control on the business until some future chosen date when they sell more that 50% of their holdings. Additionally, selling stock or membership interest has different tax and liability treatment from the asset sale as shown below.
|Stock Sale (&LLC Membership Interests)||Buyer||Seller|
|Tax Treatment||Buyer records all tangible and intangible assets and liabilities on their books without adjustment. Usually the depreciation deductions are lower in a stock sale as compared to an asset sale.||Seller usually pays capital gains on the difference between the sales price and their basis in the stock. Certain items such as consulting agreements, are ordinary income.|
|Buyer generally assumes all liability.||
Seller generally relieved of all liabilities unless exceptions are made in the Stock Purchase Agreement
On the other hand, if the buyer purchases the assets, the seller will treat this, in part, as a capital gain for tax purposes. However, the buyer will not be able to expense the purchase price in the year of the purchase; rather he or she will have to depreciate fixed assets over their useful lives and amortize intangible assets over 15 years, as summarized in the following table:
|Generally, the Buyer depreciates assets over their useful life, with intangible assets amortized over 15 years. Buyer can negotiate different tax allocation with the Seller in the Asset Purchase Agreement.||Each asset has its own characterization of gain or loss. Seller must recapture depreciation taken. Beyond that, capital gains are levied for the difference in basis in the assets and stated sales price. Certain items, such as consulting agreements, are ordinary income.|
|Liability Treatment||Buyer generally assumes no liability.||Seller is generally not relieved of all liabilities since they are not selling the business stock, unless exceptions are made in the Asset Purchase Agreement|
For those advisors with ownership in C and S corporations or an LLC, generally the sale of the business ownership is considered a stock sale (or membership interest in the case of an LLC).
Advisor and owner of these entitles may also choose to sell only the assets of the corporation. The distinction is important particularly when applied to C corporations. Usually the sale of C corporation assets is subject to the “double taxation” rules, which can have a significant impact on the net amount an owner receives when selling to a third party. (S corporations and LLCs are flow-through entities and are not usually subject the same double taxation rules on C corporation asset sales.) There are a few possible exceptions to the rule, so be careful as to discuss their applicability with your CPA.
Virtually all “outside” buyers of advisory corporations seek to purchase the assets and not the stock of the business. If an outside buyer were to acquire the stock of the corporation, they also would be assuming any future potential hidden liabilities. When acquiring just the assets of a corporation, the buyer usually circumvents liability issues that might exist from the previous ownership of which they usually have little or no knowledge.
Most internal succession strategies involving the transfer of a business entity either over a short-term or long-term period are structured as a stock sale for two reasons. The first is that an advisor is better able to capture all the inherent value in the business when selling corporate stock or membership interest by basing the sale on a market multiple built into a pre-determined formula. In other words, if the sale was structured as an asset sale, the advisor has to account for a line-item value for each asset being sold, in the stock sale, the base value of the stock price itself, already incorporates the business’s core value.
Secondly, in the case of internal successions, the successor is less concerned with liability risks since he or she has worked in the business for some time and understands the operational risks of the business. Any problems or issues are usually well known to the internal successor. Conversely, the outside buyer who has not been privy to the firm’s history has a right to be concerned with any potential unknown liabilities of the business.
Additionally the business’s sale will have different tax concerns for the buyer versus the seller.
For example, the “allocations” towards the purchase price will play a significant role in the tax outcome for buyers and sellers. In sum, sellers want more of the purchase price allocated to categories that receive capital gains treatment, whereas buyers wan the opposite so they can accelerate business tax write-offs. Both buyers and sellers should thoroughly understand tax allocation issues prior to showing up at the negotiating table.
There are issues to contend with in the various business entities such as, how many and what type of other shareholders exists, what is the basis in the stock, and what restrictions have been placed on redemptions or ownership transfers in the corporate bylaws. According to the individual agreements of partnerships and limited liability companies, a seller may also be restricted to only transferring ownership back to the partnership or its members.
All of these issues can be deal killers and therefore it is better that you understand them up front rather than late in negotiations. Because of the individualized nature of financial advisory practices, the first recommended action that the advisor must take before moving too deeply into the outside sale is to get specific tax advice from a qualified tax accountant or attorney. Only the will you be able to determine the best method for structuring the sale and what tax advantages you seek from the transaction.
Financing Methods of the External Acquisition
There are three major ways that buyers and sellers construct financing for an outside sale. None of the three are high finance methods, but they differ from each other considerably. The first is all cash, the second is on an earn-out basis and the third is through an installment note.
There are additional methods of financing that advisors employ when fashioning an internal succession plan, such as the bank-financed installment sale or the “overlapping “installment sale. Because the outside sale has higher inherent risks than an internal succession, these financing methods are not typically used.
Here we focus on the three strategies that are most often encountered when advisors are selling to an outside third-party.
At first glance, it seems that an all-cash buyout would be your best and most convenient option when selling an advisory firm. It sounds really good to receive your value in cash and walk away happily into the sunset. But as you delve further into the world of selling your business to an outsider, you will find that the reality is this method actually penalizes you. How so? A purchaser is not buying your history. He or she is acquiring the potential of the acquired firm to produce a future revenue stream and to enjoy continued growth prospects.
Because of the nature of financial advisory firms, the all-cash buyer will likely want to discount the sales price considerably to account for the uncertainty of future income streams. It is for this reason that practice sales to outsiders rarely involve cash buyouts. The buyer will usually insist on paying for the purchase by using earn-out financing (addressed in the next section).
Usually the only cash buyers found today are those who are acquiring business assets from an advisor who has been dealt a sudden catastrophic event in their lives such as a disability, major illness or death. But be very aware if you are relying on this as a back-up method for financing. In distressed circumstances, business assets may sell for cents on the dollar. Clearly, the cash buyout is not usually a method chosen by sellers who wish to maximize their business value.
The most common form of financing for an acquisition of an advisory firm in the earn-out. The
Earn-out is exactly what the name implies; the buyer is using the firm’s future earning to buy your ownership over time. The earn-out funding method is mostly limited in use to those situations where owners are selling to a previously unknown outside buyer. In a good percentage of outside practice sales, the buyer and seller were only recently introduced. Because the two parties have not established the same level of trust one would have when selling to a partner or employee, a funding tool is needed to even the playing field for both sides. Outside buyers are first and foremost aware of the risk of client attrition when acquiring a client base that is previously unknown to them. Therefore, to reduce the risk of not receiving the current revenue flow in future years, outside buyers insist on paying for the business not up front, but over time. Earn-out arrangements are funding methods, which are based on contingent payments that only pay a seller for the numbers of clients transferred to the buyer.
Usually there are two components to an earn-out. The first is the down payment at closing of the practice sale. Unlike internal sales where a down payment is usually not required because the seller is transferring only portions of corporate shares over time and staying involved in the business, the outside sale requires a down payment. The more a seller can receive from the buyer in a down payment, the less risk they incur since less of the practice value is paid through the earn-out arrangement. As a seller, it is smart to adjust the down payment to offset some of your risk for carrying the earn-out.
There is no average down-payment in earn-out deals. They can run from as little as 10% up to 60% or more. Suffice it to say, the seller should adjust the deal terms to account for the risk they shoulder in the transaction. For instance, if you are not sure of the skills the buyer has in dealing with your clients, mitigate the risk by obtaining a larger down payment in cash.
The second component of the earn-out is seller financing of the balance of the purchase price. This balance can be paid as either as: 1) a fixed price, or 2) as a fixed percentage of revenues. Examples are shown in Figure 1 below.
Two Examples of the Earn-Out Method
Some advisors who explore the earn-out method come away feeling it is inferior to other funding methods. The biggest reason for this attitude is that in this model much of the risk of timely and consistent payments is shifted back to the seller rather than to the buyer. Another reason is that they can leave the seller “holding the bag “with little or no recourse on the buyer if the ending payments total far less than what is projected when the business was sold. Unfortunately some believe that the earn-outs are a risk-free funding method. It is not risk-free. In fact, if improperly structured, a seller could receive significantly less than the purchase price originally agreed to.
For example, if you happened to have sold your business to an unknown outsider at the height of a stock market boom, the results could have been disappointing when compared to your original expectations. For example, let’s say you sold your fee-based business to an outsider for $ 1,000,000 just before the major market correction. You received 25% down or $ 250,000 and the balance of $ 750,000 on an earn-out to be set at 20% of net profits to be paid quarterly for a fixed period of the next 4 years. In this example, we will also assume that 75% of your revenues were generated from fees. In the first year of the earn-out, a stock market correction ensued and since most of the revenues were based on assets under management, revenue and net profits decreased. In the following years, payments to you the seller were reduced as the profits also continued to diminish.
Instead of ending up with $ 750,000 you thought you were due, your payments totaled $ 450,000 when all was said and done at the end of four years as shown in Figure 2 below.
Original Contract Terms
20% of current net profits to be paid each quarter over 4 year fixed period
Assumed quarterly payments were $46,875 x 4 quarters = $187,500 in annual payments
$187,500 x 4 years of payments = $750,000.00 total sales price
Final Settlement Price
Profits dropped considerably after market bust
Average payments over term = $28,125 per quarter
Final payment total at the end of 4 years = $450,000.00 total
$250,000 Less Paid For Your Business Or
40% Loss of Value
Your first thought may be to say that such market corrections only come around every decade or two and you’re not likely to get caught up with the timing. But, market corrections are not the only risk of using an earn-out. What happens if clients defect to competitors because the new buyer’s personality wasn’t compatible with theirs? What if the new buyer becomes distracted or misjudges the resources required to service the new clients and focuses only on your larger clients thereby reducing the net profits from the total client base. Also, from the buyer’s perspective, what is the penalty for performing poorly? Virtually none.
Earn-out funding models are in essence a gamble that you and the buyer can predict the future. The earn-out also assumes that your buyer will continue to operate your business as profitably as you did. The only way to compensate the seller for this risk of not knowing the future is to construct a deal with the highest possible down payment and one that allows for you to earn more than the original agreed upon purchase price if all goes well. In other words, the offsetting benefit of an earn-out for the seller is, that if they believe the assets will grow under the care of the buyer within the contract period, they may receive more payout than the original sales price.