Naturally one of the primary objectives for buyers when pursuing the acquisition of an online business is to secure the best possible deal in respect of their funds available and risk appetite. Business sellers can in many cases be at odds with this as they seek to maximise the upfront cash consideration and overall price paid. As is quite common in the world of online business brokerage, buyer and seller expectations can often be aligned by creative financing methods such as holdbacks, earn-outs, and seller financing. As such it is important to have a good understanding of the funding options for buying an online business.
Funding Options for Buying an Online Business
For most sellers, an all cash offer is the most preferred, risk free option, but there are many situations where making an all cash offer is not the most sensible way for a buyer to move forward. Often, where the business for sale is based in a foreign jurisdiction, has complex operations, is relatively new or is very large, creative financing solutions are required to satisfy the needs of both parties.
Every buyer is in a unique financial situation and as such, would benefit by understanding the options available to them. In this article we discuss the most common funding options for buyers of online businesses and show how these have been used through transactions completed through FE International so far this year.
Cash forms the primary (and usually largest) tranche of the total consideration in most online acquisitions. Buyers tend to look to their liquid assets to meet the cash requirements and many limit their search to their bank accounts, which can limit the ability to make offers on a business. Numerous buyers have seen success in more unconventional methods of cash raising, including (but not limited to):
- Retirement funds: cashing out a portion or all of their retirement accounts (401k, IRA, etc.);
- Borrowing: Borrow from a 401k account (up to $50,000 is allowed in the US);Taking regular IRA pay-outs (must do so for the next 5 years);
- Securities: taking a loan against securities/equities;
- Roth Contributions: Taking back a Roth Contribution can be an option for buyers over the age of 59 ½ in the US;
- Small Business Administration (SBA) – third party guide on how to apply
- Asset Based lending / Collateral based lending
- Business partnerships/JVs: Finding someone with cash and/or experience
- Peer-to-peer lending: prosper.com, lendingtree.com, etc.
Note: The value of your investment can go down as well as up so you may get back less than you originally invested. It is recommended to seek professional advice from a relevant expert before pursuing any of these (or other) options.
What Else Can I do?
‘How about creative financing?’
This typically refers to scenarios in which the total consideration is comprised of a cash tranche and other tranches to be paid over a specified period on agreed terms with the seller.
To demonstrate using a simple example, a buyer and seller have agreed on a $100,000 offer for XYZ.com, which generates $40,000 in net income per year (2.5x annual net income multiple). The cash consideration stands at $80,000 and the remaining $20,000 is to be paid to the seller after the deal has closed.
One common form of seller financing is an amortised loan. In this scenario, the buyer would agree to pay the outstanding $20,000 to the seller over a set period of months at an agreed interest rate. The example below is based over 12 months at an interest rate of 5%:
In this case, the buyer will pay the seller the full $20,000 over 12 months, plus $546 in interest. The total consideration of the acquisition is the sale price of $100,000 plus the $546 in interest (Total: $100,546).
On a monthly basis, the buyer will be paying $1,712.15 to the seller, which is 51% of the net income of the business based on the last 12 months history. This leaves plenty of room for fluctuations in the monthly earnings, assuming monthly revenues are equal over the course of a year.
Thoughts: This is certainly a popular option as it removes the red tape and often slow pace of dealing with a bank or other financial institution, however, a buyer needs to be careful when signing agreements without proper consideration of future cash flows – a default on a scheduled payment may prove costly and in some cases can result in the seller taking back possession of the assets without surrendering any consideration paid up until that point from the buyer.
In an earn-out the buyer agrees to pay the seller a percentage of either the revenue or the profit of the business for a set period of time. This is used in situations where the business may be young, have erratic cash flows or an uncertain future, so the buyer wants to leverage the seller’s knowledge and resources in an attempt to run/grow the business in the period immediately post-sale.
In this case, the buyer will need to project the future cash flow of the business based off historic figures, as well as micro and macro industry data. Most earn-out calculations will be far cruder than a full detailed valuation analysis (i.e. a Discounted Cash Flow model) but the buyer and seller must ensure they agree on what the site is expected to earn over the earn-out period (all things being equal), to avoid disputes at a later stage.
In the example presented, the business generates $40,000 a year in profits. In order to pay the total implied consideration of $100,000, the buyer would need to agree to split the profits of the business 50/50 with the buyer on a monthly basis.
The seller is again taking a risk that the buyer will not default on payments or not run the business into the ground, so in exchange a seller may well ask for a higher total implied consideration (say $110,000). This would usually be achieved by extending the earn-out period beyond the 12 month period rather than increasing the profit split, to achieve a total implied price they are happy with.
Thoughts: In this scenario, it is important for a buyer to accurately forecast the future cash flows of the business with the most relevant data available (both quantitative and qualitative). A buyer must also be aware that the performance of the business can go down as well as up, even with the help of the seller. If the revenues go down over time, the buyer must ensure they are able to cover any external financing obligations that may have been set against the profits from the business.
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A holdback agreement is sometimes used in larger deals where a business may be reliant on certain arrangements staying in place, such as long-term service agreements or employees of the business continuing to work for the firm. Even though online businesses can be far simpler to run than offline businesses, there can still be many moving parts. A buyer should be aware of the variable elements and protect against a material change in any of them in the near future. A holdback might also be used to verify certain revenues or costs, that cannot be fully explored pre-sale (i.e. chargebacks, refund rates, etc.)
Although it would not usually be applicable on a $100,000 transaction, in this case the buyer would offer $80,000 in cash and $20,000 to be paid at the end of a chosen date, held against milestones such as (but not limited to):
- Post sale obligations by the seller being met such as training a newly hired contractor or help setting up a paid advertisement campaign
- Contractual agreements in place at the time of sale being fulfilled such as getting a merchant account approved and setup or verifying income from advertising networks that pay every 30 days
- The business hitting certain targets, i.e. maintaining the LTM gross revenue averages
Thoughts: A seller may underestimate/understate the value of contractual or other arrangements and post-sale obligations, so a buyer should look at case studies of other similar businesses to ascertain what may and may not affect the future performance of the business. A full due diligence report on such activities may highlight some areas of concern in relation to this and areas which are difficult to verify before the assets swap hands.
This is an uncommon option as most sellers wish to move on to something else post sale and equity is often offered in exchange for services (similar to a Service Agreement, but with a profit share based on equity ownership). In this case the buyer could offer $80,000 plus 20-30% equity in the business to the seller. It would be an on-going partnership, with both parties sharing in the long term success of the business.
Thoughts: This would require extensive legal drafting, not only with the Asset Purchase Agreement, but with a Partnership Agreement and other legal documents. There would likely need to be a legal arrangement with regards to the entity, whereby both the buyer and the seller are shareholders in the parent firm. This may cause costs only worthwhile on larger acquisitions or where there is a strategic benefit going forwards for both parties.
In some cases, such as with websites that require regular content updates or product launches, the buyer may offer the seller a service agreement as part of the total consideration. This is typically offered by sellers if the buyer is concerned about the skills and expertise required to run the business, and is not considered a form of financing.
A buyer would offer the seller a fixed monthly fee in exchange for a pre-agreed set of defined tasks. The total consideration of the business would remain the same, but the total value of the service agreement would be held by the buyer and released periodically (usually each month) on completion of said tasks.
Using our example, the buyer would pay the seller the cash consideration of $80,000 and pay the remaining $20,000 on an equal monthly basis as part of a service agreement. This may be supplemented by revenue sharing incentives or other bonuses based on the performance of the business. This differs from Seller Financing by the fact that the agreement is contingent on a series of tasks being completed in order to receive payment, whereas Seller Financing does not require the seller to meet any requirements.
Thoughts: A buyer may struggle to convince a seller to accept a structure like this – the more the business is susceptible to key person risk, the more a seller might be open to it. If the buyer is proposing such an arrangement to maintain the site in a passive manner, rather than due to a specific function of the business that is beyond their own skill/ability, the seller may well ask for the agreement in addition to the total consideration of the business.
A buyer should also keep in mind that this agreement may fall outside of a typical Asset Purchase Agreement, so there could be increased legal drafting costs incurred. The seller may also lose interest over time, as the reason for sale is often to start new projects. This may affect the quality of the service provided over time.
Financing in Context
‘So how does this play out in real life?’
Out of the transactions completed by FE International so far in 2014 to date, we have seen the following structures across all deals:
The distribution above is relatively consistent for acquisitions in the sub-$1m range. Beyond this valuation range, the balance tends to start to shift depending on the total business size and its model.
‘So why pay cash?’
The popularity of all cash offers is decidedly simple. It tends to afford buyers some flexibility in the asking price as sellers typically try to avoid terms that extend beyond the closing date of a transaction.
The All Cash Deal
‘As a buyer, you are more likely to get a better price if you make an all cash offer.’
Out of the same set of transactions completed by FE International in 2014 so far, only all cash and seller financed deals saw a discount to the asking price. Many of the other deals completed under the other various structures saw the buyer paying above the market price in exchange for the additional flexibility offered by these arrangements. This shows the power of an all cash deal.
‘So I should try and pay all cash?’
The numbers above make for a compelling case in favour of all cash and seller financed deals, but a buyer needs to assess the situation on an acquisition-by-acquisition basis. There will be many factors that play a role in the offer structure and there is no blanket solution that a buyer should apply to all deals.
A good business broker should be able to guide a buyer on what might be optimal in each individual situation.
There are numerous ways to supplement the cash tranche a buyer is willing to use or has readily available to purchase an online business. A buyer can strengthen their position, mitigate risk and move up the purchasing scale by using a variety of options presented in this article – the options do not stop here, but these are the most commonly used examples seen by FEI.
As a buyer you should be mindful that competition exists and in order to secure the right acquisition, the offer that prevails is often the one that meets the needs of both the buyer and seller. Buyer competition does exist (and is increasing year-on-year), so as a buyer you would be wise to ascertain the objectives of the seller early on to find a structure that is fair for all parties and mitigates as much risk as possible, on both sides.
If you have any other questions, please get in touch via email or the comment section below.