Financial Deal Components: Financing & Rolled Equity

Explore the world of financial deal components in this episode as we break down seller financing, SBA loans, and rolled equity. Learn how different financing structures work, when to use them, and the risks and rewards they bring to both buyers and sellers. We also discuss critical factors like interest rates, senior debt, and second liens, offering insights to help you navigate complex business transactions. Whether you're planning to sell your business or exploring funding options, this episode is packed with actionable advice.

---

TRANSCRIPT

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has

partnered with small business owners to prepare for and navigate the business

transaction process. Pull up a chair as we share stories and insights from our

experience on all sides of the M &A table. Well, going to today's podcast.

Today, we're going to be diving into financial deal components. And so we'll go

ahead and start with seller financing. And to some of you who may be listening,

this could be a little elementary to you. But there are a lot of nuances to seller

financing and a lot of different components to it. So we're just going to dive in.

So Dave, Andrew, when is the best time to use seller financing. Oh,

man, yeah, the best time to use seller financing, I mean, I think it's going to be

based on the buyer, and so the buyer needs to fund it in different ways,

and so on a previous episode, we kind You know,

we don't When you're the seller you don't really you may or may not really want to

Finance the deal if you're gonna be behind a series of debt, right? And so and so

the Really, it's it's just a way that you can allow a Different source of funding

for someone to buy your business and so the best time. I mean,

a lot of individual buyers, I mean, they'll go to a bank, but a lot of times they

might, a seller might finance a deal to them. Those will be smaller deals,

pretty popular, although SBA is very popular as well. And so you don't necessarily,

you don't always necessarily need seller financing. And so really,

Really, it's your appetite. That's what I would say is the best time is to figure

out what your appetite is or you willing to wait a little bit to get your money

for your business. That's essentially what it is. Let me pipe in here on the SBA

thing just for a moment because I think that's important. So a lot of smaller

deals, SBA is lending up to, I think it's 5 million right now and I think that

they're getting ready to raise that up almost seven or so, seven and a half. And

so actually we do have a lot of requests for seller financing in SBA deals because

here's why. Most of the people who are buying a small business may not have a lot

of liquidity. They may not have a lot of cash sitting in the bank to use. But if

SBA is gonna require 20 % down in that particular deal or percent down, they've got

to figure out if it's a $5 million deal. Well, that could be a million dollars. So

what they will allow up to a certain extent is they will allow a seller to seller

finance part of that down payment to the buyer. But they will put stipulations

around when that can be paid off and at what level it can be paid off, how

quickly quickly can be paid off and oftentimes it can't be fully paid off until the

loan to SBA is paid off or it reaches a certain amount. That's a little bit of

negotiation that can happen depending on what bank you're using. And so, that's one

way it can be used really effectively because some of these smaller deals just

wouldn't get done. I think I've said it before, like 80 % of smaller deals have an

element of that, but let's talk about just in general what it is. Yeah, Dave, let

me add in there as we're on the topic of self -financing and SBA, and what I've

heard or what I've learned is that if that 15 % is,

I mean, SBA is going to require most likely 15 % as kind of a down payment,

and I'm I'm no banker. And so, you know. We all have a bank run here with us

though in these days. Yeah, I know. And we'll definitely get a banker, an SBA

lender to come and to teach us a little bit more. But I think that, you know,

when we're kind of going after a business, if you're buying and you don't have that

15%, there are times where that seller financing of the seller can can kind of

accommodate for that. However, they cannot, the only sort of payment that they'll be

able to get before the SBA is completely paid off is interest payments.

And so, I mean, that said, you know, we can kind of figure out ways around that,

especially if you can pay for that 15 % or if you can, yeah, pay for that 15

percent down payment, then any other seller note, you can actually pay that off,

but it is going to be secondary to the SBA. So one thing that was pointed out to

us is that we use a lot of these senior debt, primary debt, and we had some

listeners say, "I think we need to explain a little bit more about what that

means," and that's understandable sometimes, like we always say with these silly If

you talk to, I always laugh because when you meet PE groups and stuff,

new PE groups, especially large ones, they're like throwing acronyms out left and

right. I think it's like this, you know, intimidating acronym volleying going back

and forth, which I find extremely silly at my age. But so let's just be really

elementary about this. Everyone, if you own a home, you went and got a mortgage on

your home more than likely. And, and some of you may have taken a second mortgage

on your home. It was, it was very, we used to own a mortgage company, it was one

of our businesses. We would often, because they wouldn't have to pay mortgage

insurance if the, if the, if the first lien, the primary mortgagee,

mortgage lender was at 80 % or at, yeah, if they were at 80%,

they wouldn't have to pay mortgage mortgage insurance so but it's only had 10 % to

put down that meant that there was 10 % of that 100 % so if you buy a house for

$100 ,000 first lender the main lender the senior lender in that case we would call

them is going to loan $80 ,000 you've got $10 ,000 to put down that leaves that $10

,000 gap we would fill that with a second lien from a different bank,

a higher interest rate, possibly a shorter term, and they would be in second

position. If I foreclosed on that house, or if I walked away from that house, or I

couldn't pay my house payments, the senior lender, the primary mortgage person who

lent me, loaned me $80 ,000, they would come after the house first.

They have first priority on the on the collateral. If that collateral is satisfied,

then the second lean people would get their share if there was anything left. Let's

say they sold the house for $85 ,000, they satisfied their $80 ,000,

then the second lean got five, and then they would be out of luck on the other

five. So it's a higher risk loan. In the M merged with the acquisition world,

you would call it senior debt. It would be a little less expensive. It may be from

a bank. It may not be from a bank. It may be from people who specialize in senior

debt. They may also be taking some equity position in the deal. There's different

ways that that is done from a buyer side, which we're not really talking about.

But, and then you also hear this term mezzanine debt or mezz debt, which is

basically a second, they're in a second position on that debt. And so when we start

talking about seller financing, what becomes important to us as M &A advisors is if

I'm selling your business and they're asking you to be, they're asking you to

finance part of that, I'm going to help you determine what interest rate to charge,

what would be kind of market in that, because it's going to be, it's not going to

be the same rate as a first lean lender, you're gonna get more interest rate, you

hope. It's gonna be on a different term as far as timeframe. And you can discuss

the terms. If maybe a business does a certain amount of business, maybe it's

accelerated in its payoff, or there's different ways to work that out. But what I

really wanna understand is if that company fails, or if they stop making payments,

what's your recourse? What's the collateral you have to go back on? And also,

what position are you in? How much money is in front of you? So a lot of private

equity deals come in, they're coming in with maybe 20 or maybe 30 % of equity, and

then they're financing up to 70 % of the deal. Or maybe they're financing 50 with a

senior debt, that's just a lot of money to be in front of you. And a lot of

buyers or sellers are like, "No, I don't want to do that." Unless they understand

what their position. And then how do you protect it from not being diluted to where

another lender can stand in front of you at some point? Does that make sense,

Mason? Is that kind of... Yeah. Yeah. No, that makes sense, for sure.

So you mentioned the interest rate and we determine What goes into setting the

interest rate? How do we come up with the interest rate that we would advise a

client on? - Well, you know, for a while, I mean, we were probably doing, you know,

if a seller was getting, you know, 7, 8, 9 % on a second lien, that wasn't too

unusual. But right now, that's what first lien, that's what senior lenders are

charging, eight, eight, eight and a half somewhere along in there. - That's what

prime is. - Right, so The latest, the latest deal I saw come across was somewhere

in the 10, you know, 10, 11 % range. And it could be that it maybe it moves with

Prime as well, kind of like the senior debt does. Yeah. So the other thing I think

you have to realize is what's the collateral. So we, we do a lot of deals in the

healthcare space and a very specific healthcare clinic type space?

Well, it's a freestanding emergency room. So we do a lot of deals in that. And one

thing that we have to be very cautious of is when a bank is looking at doing a

deal, they want to make sure that they have the accounts receivables. That's a big

part of the asset they want their clause into. And understandably so,

right? Because that's where the values, if the business goes down, they can continue

to collect on those

Well, you know, that is one piece of collateral that a second lien will not be

able to be secondary to, more than likely. I mean, they might be able to be, but

the bank is going to have to, the bank is going to basically have to subordinate

or basically say, we understand that there's someone below us and that you're going

to have to basically say,

one giving, if you're the one offering the seller financing, you're going to have to

sign a subordination agreement saying you understand that the bank has first position

in that. But, you know, sometimes those are tied to separate lines of credit. And

so it's just another reason you've got to have people who understand the nuances of

all of this and all the different options to be on your side. Yeah. And honestly,

I think that it's interesting to see bankers respond to these higher interest rates

right now and so just you kind of see people being a little bit more creative and

I say that very conservatively because I think bankers probably don't want that to

be-- Creativity and bankers don't always go hand in hand. Yeah, they're not really

Anyway, but although we've got a couple we deal with it can get really creative

That's why we love to deal with them But they're deal bankers, which is great and

there are our different promotions that they'll come out with and so really Just

just talking with different bankers. Don't just talk to one talk to a few and And

kind of see what what else people are offering You just you just don't know and

although they might be similar similar, you know, there might be some differences

that might go into that might be that might benefit different deals differently.

Yeah. And by the way, if we've got by say, if you've got people here, there's a

lot of our potential sellers that we're talking with that are wanting to tech in

companies, they're out looking for buy side deals, right? So we're, we've got a

couple of people out right now that are out buying a couple things and then they're

going to turn around and sell in a year or two. So and what And what we have

learned with banks, you've got your major banks that are when those are names,

but then there's these tertiary banks that are not as well known.

They might have a pretty good sized retail presence in some parts of the country or

whatever, but they really love deals, and they love to do transactions. They don't

necessarily care if it's connected to real estate like a lot of banks. They get

creative. They may not be the least expensive out there, but when you find a good,

what we call a deal bank, a bank that likes to do deals and they understand the

nuances of M &A, it's a game changer. - So when would we recommend seller financing

to a seller or not

Well, I think I think we recommend it when it makes sense from a whole structure

standpoint and when they don't have too much risk and if It's gonna be business by

business Mason really because if someone really believes in their business and they

know it's solid It's a company that's been around 30 40 years and it's on a great

trend and he's got management in place He's he's probably in a pretty safe position

a lot of a lot of owners want that because they want the additional income They

want the retirement income coming in, that's just a way for them to keep, you know,

if a good interest rate on money that's owed to them, as long as it's,

you know, mostly secure. There are times I would not recommend it, and I always get

a little bit of a red flag in my gut when someone wants a large piece of it.

What that tells me is that they don't have the credit to be able to do it on

their own, which then which then makes me wonder,

and that could be just because maybe they're new to the acquisition business and

they're trying to do their first deal, which is great because, but I'm not sure I

want that to be experimented on our client.

Or if it's a large amount, if it's a large percentage of the deal, my mind goes

to why aren't you getting this elsewhere? Or if Or if there's hardly any equity

being brought in, let's say that they've got a senior debt of 70 % and they're

wanting our client to do another 20%, it means they're coming with 10 % equity. I

mean, I'm not really big into deals that are only 10 % equity. 'Cause I just think

that, you know, we're starting to see more and more equity being brought to the

table, which we can get into when we talk about rolled equity, You know, that's

that's when I would get a little bit hesitant. Yeah Let's go ahead and talk about

rolled equity. When is the best time to use rolled equity in a deal?

Yeah, you know just like Dave mentioned their Equity is just the term equity not

not just rolled equity. We're seeing a lot of equity Come to the table.

I mean with your financial buyers, you know, they're they're looking at financing

deals through two major means, right? Debt and equity, and so,

and that can be split up in whatever ways that you want.

It could be investor cash, it could be their own equity or cash, it could be the

seller's rolled equity. Dave covered the debt portion of it,

and really Just like debt, there's many types of equity and what's the order or the

capital stacked, if you will, but really, it is fascinating to see people really,

recently, we've come across a handful of these buyers where they're wanting to,

or they have the cash, right? They have the funds and they're wanting to spend more

of it rather than leverage for the company. And I think that it's just fascinating

to see that. I think that kind of also generates a little bit more of a kind of,

you can call it patient capital, I guess, if you will, where people are looking at

more long -term investments holding the company long for a longer period of time and

so because people are are looking at equity as a source of funding.

They're really wanting to see the seller as part of that funding and so we enter

into this world equity portion of a deal. And so really,

that's what's fascinating about this conversation of Roald Equity.

But to be clear, Andrew, just to make sure that we've got everyone with the

defining of the definitions, Roald Equity is when a seller chooses to rather than

take cash for a certain percentage of the company, they're going to roll their

Ownership into the new coer into the new or it could be that maybe they're buying

and oftentimes they're buying the current corporation They're they're gonna retain 20 %

Say it's a 20 % rolled equity. They're gonna retain 20 % in the new company and get

the upside if there is any in the future We've done that with some of our

companies And we've seen upsides work. I mean we called the second by the Apple.

That's rolled equity versus what we're really starting to see, I know what you're

talking about is just the buyers coming to the table with more cash, more equity

rather than debt. - Yeah, yeah, one of the questions that I ask any buyer now is,

I mean, talk about debt to equity ratio, right? I mean, how are you planning on

financing this deal? And so most of the time they'll answer, we really want to keep

it at a 50 /50 or even more equity than debt.

And it's fascinating. I don't know if that's, I can't say that's always been that

case. No, no, it's been, typically you could pretty much count on 30 % equity, 70 %

debt. In most private equity deals, where PE deals, you know, private equity deals

because they're looking and it's the right formula for them because they're looking

at flipping that thing in three to seven years depending on what their mandate is.

But interestingly, so the way it works in our companies, Andrew normally finds these

different buyers and at some point he gets me on the phone with them if it's a

deal I'm involved with and I'll kind of talk to him a little bit, we'll kind of

find out their history, do they have a trading deals or, you know, coming back to

the last minute, wanting a different price is often done. You know, there's these

different things we just want to kind of flush out at the beginning because we

really don't want a lot of, we just don't want a lot of confusion. We just want

there to be a really straight up good deal, everyone being on the table of things.

And so we were, I had my typical conversation. So how much equity and how much

debt and they said, oh, we do all equity. I went, what do you mean you do all

equity. Oh yeah, we do all equity. We don't do debt. I was like, what? I mean,

this was a large deal. But it put us on, we started really listening in the market

more and we've seen more and more of these folks come up. And a lot of them are

investing institutional money. So they're investing money from universities on the

endowment programs and things, which is great because their mandate was, we don't

sell for 20 years. we're going to buy and hold. So it would make sense on a buy

and hold not to leverage it up, but to put a lot of equity in it, especially if

there wasn't an expectation of a large payback right away. And so, you know, that's

what I know you're running into more and more, Andrew. And honestly, we're out

looking for those buyers because those buyers, I would recommend someone do a second

lien with someone like that. When there's no debt in front of them, that's a great

time to do a second lane or a seller finance. Yeah. Yeah, I can't say it.

Yeah, exactly. But I think that when you are going to either stay in the business

or you trust the management team to take it and continue on,

if you're going to exit, I think that unless that's a So I would maybe almost

recommend not doing it, but those are things that need to be in place for sure.

- Yeah, go in deeper on what you said, not recommending doing it. When would you

absolutely not recommend somebody do rolled equity?

- Many times.

I would, look, I mean, it, I mean, I think in a couple of other previous episodes,

we've talked about a couple of different offers and I think the last time we

covered this topic, we mentioned this one offer and it was a proposal where it was

promising a lot and that's one red flag that I see is when they're over promising

or wanting to point you to what they're promising. Yeah, exactly. And look,

we try to take those rose -colored glasses out off, right? I mean, you can't wear

those when you're looking at an offer. That's why I have my business partner. He's

a CPA. He's always got the rose -colored glasses where it's grant when you need

them, right?

I'm like, "Let's go get 'em, let's make 'em crazy." He's like, "No, no, no, that's

a horrible deal. Terrible deal, stay away from it." - Oh yeah, you kind of need

that cynical side to you, right? I mean, that's essentially what you, I mean, you

have to look at what's realistic. And I mean, when you're only looking at what is

being promised, or if that's what's being put in front of you instead of anything

else, then it's, I don't necessarily recommend going at least with that buyer if

you're going to roll equity. And so it's more situational than it is a general,

hey, would you recommend roll equity or not? So it's an investment strategy, right?

I think this might be a good way to kind of piece up is, you know, with, with,

um, you know, we were at a conference not long ago in Missouri, and we're, and

listening to a lot of buyers talking about, you know, and they were saying, look,

if you do, we stay in this lane, this is our, maybe it's healthcare. We, we only

invest in healthcare because we know it really well, or we only invest in technology

in this particular arena because we know it really, really well. When we start

straying outside of that, we get in trouble. And that discipline is what helps

really good buyers do well. And so I think it's the same thing with if if I'm if

I'm willing to roll 10 or 20 % of my hard earned value in my company over to

someone else, and I don't know that they know what they're doing, or if they're not

going to use my management team or if now my company is becoming a tuck -in and a

platform and I don't know any history about them you know that would be like me

getting out of my lane you know but if I've got my general manager who's coming

along for the ride and he's got equity and you know and everything kind of lines

up well and I believe in what they're doing and I've asked enough questions about

the vision of that company but if I don't know where they're going and I'm not

really you know we've all We've all taken pot shot investments here and there and

we gotta go, why did I do that? I mean, it was an emotional thing. And we're

looking in the future of what it could be rather than what it realistically most

likely will be. And I think so, that's when I would say, I don't, you know,

if you're not gonna have any sort of insider control going forward and none of your

people are gonna be involved and they don't have a history of running this kind of

company. I wouldn't recommend it to a client. Yeah. Yeah, that's great wisdom. Well,

that's all we have for today. Thanks for tuning in to today's podcast and we'll see

you next time. And that wraps up another episode of Integrated Insights with ICCG.

Be sure to subscribe and stay tuned for more stories from our team. We love hearing

from our listeners. If you have any questions or topics you'd like us to cover,

please send us an email in the show notes. For more information about ICCG, please

check us out on our website or follow us on LinkedIn and YouTube. Until next time,

there's always a seat at our table.