When a buyer purchases an existing business, there is always risk that comes with the investment. Although the buyer is given the chance to perform their Due Diligence (an examination of the business’s financials and operations, to the buyer’s satisfaction), a buyer is often concerned that they could become responsible for the seller’s debts or liabilities after closing. The way that is addressed in most asset purchase contracts is with a “Seller’s Indemnification and Buyer’s Right of Set-Off”. In the Florida BBF Asset Purchase Contract, it looks like this:
21. SELLER'S INDEMNIFICATION AND BUYER'S RIGHT OF SET-OFF:
21.1 Seller indemnifies Buyer and shall hold Buyer harmless from all debts, claims, actions, losses, damages and attorney's fees, existing or that may arise from or be related to Seller's past operation and ownership of the Business, except for any liabilities specifically assumed by Buyer hereunder.
21.2 In the event Buyer should become aware of any such claim against the Business not disclosed prior to Closing, Buyer shall promptly notify Seller in writing of such claim. In the event Seller does not satisfy said claim or said claim is not disputed within ten (10) days from the receipt of such notice:
21.2.1 In the event of an owner financed transaction, Buyer may, at its sole option, pay such claim and receive full credit against any Promissory Note payment owed to Seller under this Contract.
21.2.2 In the event of a cash transaction, the parties agree that the Closing Attorney shall retain $ ______________ from the Seller's closing proceeds for a period of _____________________ (____) days after closing to secure the Seller's indemnification as provided for in this paragraph.
There are two different features of a business sale that can work to mitigate a buyer’s fear of this situation occurring: a seller note and an escrow holdback. Here we will examine those items more closely and talk about why they might be important to some buyers.
What is a Seller Note?
It is seller financing; the seller will hold a note on a portion of the purchase price of the business. Seller financing is sometimes also referred to as seller carryback, seller carry, or owner financing. The tangible assets of the business are normally used as the security for the loan, but many times a buyer can be asked to personally guarantee the loan with private collateral. The seller has the right, and should (in our opinion), perform Due Diligence on the buyer, to determine if they are a borrower that they are willing to lend to. If the buyer does end up in default, then the seller keeps the buyer’s down payment, in addition to receiving the business and its assets back (must go through the legal process to get it back). Typically, the closing attorney will be able to draw up the promissory note for the parties to sign at closing, for an extra fee. This fee is customarily paid for by the buyer, but it is up to buyer and seller as to how they want to handle it.
What does a Seller Note Normally Look Like?
Typical down payments required by sellers are large. 50% down is the most commonly requested amount by sellers, but it is completely up to the seller as to what they would accept. In fact, we see 20-30% down payments happen frequently. The term length of the loan is usually very short. 3-5 years is what we see most often. Normally there is a balloon payment at the end of this short term, but monthly payments can be amortized over a longer period of time, to decrease the monthly payment amount. Interest rates are negotiable, but usually a little higher than a bank loan. However, there are no large closing costs involved or bank fees. We typically see 7-9% these days.
Also, it is fairly common for an SBA lender to request that the seller contribute to the down payment of the loan they are funding for the buyer, so we often see sellers offering 5% owner financing to assist with that.
Why is a Seller Note Important to Buyers?
By offering seller financing, it shows to potential buyers that the business owner believes in their business and they are confident that the performance of the business will be able to pay back the loan. By granting the buyer a seller note, the seller still has some ‘skin in the game.’ They have a vested interest in making sure that the business continues to be successful, and the buyer knows that the seller is behind them. This instills buyer confidence in the business, and also opens up many more possible buyers who might not have the entire asking price available in cash. Buyers also prefer seller financing to traditional financing, because no banks are involved, resulting in no bank fees for borrowing. Furthermore, in many standard asset purchase agreements (check with your business broker to see if yours includes this), there is a provision in the contract where the seller indemnifies and holds the buyer harmless for any undisclosed debts or liabilities the seller acquired during their prior operation or ownership of the business. In the event of seller financing, the buyer is allowed to pay a claim that arises after the sale, which the seller is responsible for and refuses to pay and receive full credit against any Promissory Note payment owed to the seller. This acts as a safety net for the buyer, if they are worried that they might be held responsible for any past debts of the seller.
What is an Escrow Holdback?
Escrow Holdback is a common negotiable item found in standard asset purchase contracts for businesses. In a nutshell, the parties agree on how much money and for how long, will be held back from the seller’s proceeds after closing in an escrow account (usually maintained by the closing attorney/escrow agent). Usually, the amount agreed upon varies widely, based on the size of the business and its regular monthly expenses. Really it is whatever buyer and seller are comfortable agreeing to. The time frame we normally see for this is between 30-90 days, but again, it is completely negotiable between the parties and really depends on the unique circumstances of each business sale.
You can absolutely include an escrow holdback in a contract for any reason really, but seller’s indemnification is the most common. Escrow holdbacks for other reasons would be highly unlikely and completely situational. They would normally are added because of something that arises during the contract to close process in a business sale transaction, which won’t have a definitive outcome or solution until after closing. So, it acts as a safety net in these situations as well. Essentially, buyer and seller agree to set aside a certain amount of money to remedy a situation after closing.
Why is an Escrow Holdback Important to a Buyer?
Should an undisclosed debt, which is the responsibility of the seller, become due after the sale of the business, the buyer needs to notify the seller and the seller is obligated to pay the debt if the debt was acquired when they owned the business. However, if the seller refuses to pay and the buyer is obligated to pay, then the buyer can make a claim on all or part of the funds held in escrow. If no claim is made on the escrowed funds during the pre-determined amount of time, then the funds are then released to the seller. This is similar to the situation we described above with seller financing, but normally, if there is seller financing in a deal, we wouldn’t do both seller financing and an escrow holdback, unless we were using the escrow holdback for something other than the seller’s indemnification.