Are you thinking of selling your small business but the idea of offering seller financing or having it pre-approved for a bank loan is giving you second thoughts? Does a buyer already have his sights set on your business but he doesn’t have the funds to purchase it? Luckily, there is a way to have your cake (sell a business) and eat it too (without debt).
Here is the answer: Have the buyer access his retirement funds on a tax-deferred basis to buy your small business.
Why would a seller prefer a buyer to use retirement funds to buy his business as opposed to other forms of financing? And why would a buyer consider using retirement funds to buy a business?
- Ease of access– Buyers can quickly access their retirement funds, whereas obtaining bank financing is costly, time-consuming and difficult. Sellers more readily accept an offer from a buyer who uses retirement funds to buy their business, whereas most sellers are reluctant to accept offers subject to financing due to the traditionally high failure rate of obtaining a bank loan to purchase a business.
- Cash at closing– Using retirement funds creates a win-win situation for the seller and the buyer. The buyer can easily access funds to purchase the business, and the seller receives cash at closing.
- Streamlined process– The process of accessing a 401(k), IRA or other retirement funds to purchase a business is relatively quick and easy. Compare this with the process of obtaining a bank loan, such as an SBA 7(a) loan, which is time-consuming for the seller and the buyer. When obtaining bank financing, a buyer is often required to prepare a business plan and projections, in addition to dozens of other document requests. These strict requirements are not present when a buyer accesses retirement funds to purchase a business. As you can see, a seller will be more reassured when accepting an offer in which the source of funds is the buyer’s retirement account.
- High success rate– Once an initial screening takes place, the likelihood of being able to access retirement funds to buy a business is high, well above 90%. Compare this with the process of obtaining a bank loan to purchase a business, which can take weeks just to receive a preliminary approval.
- Low cost of funds– When selling a business, accepting retirement funds can be less expensive for the buyer than using bank money. Simply stated, banks charge interest. A buyer can easily pay over $100,000 in interest on a $500,000 loan over the life of that loan. Compare this with the use of retirement funds as a source of financing — retirement funds are the buyer’s own money, and there is no interest to pay. While there are fees associated with administering a retirement fund, they are significantly less than the interest charged on a bank loan.
- Creative deal structures– The use of retirement funds allows for creative deal structuring. This structure can combine other sources of financing, such as traditional or SBA bank loans, without causing complications. Because the retirement funds are treated as the buyer’s own money, subordination of financing will not be an issue.
- Can be used as a down payment– Retirement funds can be used as a down payment on a business. This can be combined with other forms of financing, such as seller or bank financing. For example, we recently sold a business where the buyer used $100,000 of his retirement funds as a down payment, the bank financed $700,000, and the seller carried a note for $100,000. The deal would have been impossible without access to the buyer’s retirement funds.
- Credit score not required– Credit scores are not considered when accessing retirement funds. It is the buyer’s money. The buyer is not borrowing money from a bank, and therefore no minimum credit score is required.
- Multiple purposes– The funds, once accessed, can be used for a multitude of purposes, including working capital and purchasing new equipment or other corporate assets.
- No debt– Some people seek to avoid debt at all costs. A buyer who uses their own money, such as retirement funds, is not creating debt.
- Maximizes cash flow– Less interest to pay equates to higher cash flow for the buyer. This can help justify a higher purchase price if cash flow is strained when preparing financial models that incorporate some form of bank financing.
- Tax benefits– The use of retirement funds presents many tax benefits for the buyer of a business, including the ability to set aside additional tax-deductible funds post-acquisition.
If a buyer has less than $50,000 in retirement funds, it is often cheaper to simply take the distribution and pay the associated taxes and penalties. If the buyer has in excess of $50,000 in retirement funds, then the benefits above apply and this deal structure may be used.
Note that this source of financing is available only to individuals. Companies use alternative sources of financing to finance acquisitions.
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Although retirement funds have several advantages to both the seller and the buyer of a business, bank financing should not be discounted. In the absence of other forms of financing, bank financing is critical.
How does the process work?
The buyer creates a new entity, a C Corporation. The C Corporation creates or issues stock. The corporation then forms a profit-sharing plan. Afterward, the buyer rolls over the retirement funds into a new retirement account. The funds are subsequently exchanged for the newly issued shares in the new entity. The cash in the corporation can then be used to purchase a business or other corporate assets.
One warning — do not do this alone. Always use the advice of a professional when setting up this type of account. Employee Retirement Income Security Act (ERISA) and Internal Revenue Service (IRS) penalties apply if the buyer does not comply with the rules.
Why do we love this strategy? Frankly, it is a win-win situation for everyone involved. For the seller, it creates a simplified and streamlined process with a high success rate. This means that a seller can accept an offer without worrying whether the buyer will be able to obtain financing. The buyer, on the other hand, will reap many benefits, including ease of access and low fees.
Learn what other types of financing buyers can use to buy your small business from my latest book, The Complete Guide to Selling a Business.
