Whether you are buying or selling, it is important to understand what is being bought and sold and what expectations both the buyer and seller have of each other. Absent these details, it is difficult, if not impossible, to determine if an offer is fair. After all, “fair” is a relative term. The question of fairness would be easy to answer if all deals were done the same way, but the reality is they are not. Nonetheless, there are still common attributes to most deals that can shed light and aid in understanding the underlying terms. This in turn helps both buyer and seller assess the reasonability of an offer.
WHAT IS BEING BOUGHT AND SOLD?
The sale of many, if not most, financial service businesses are completed as asset sales as opposed to stock sales, where all ownership rights are transferred to a third party. Since financial services businesses are primarily relationship-based, what is mainly being sold in an asset sale is the seller’s intangible goodwill. This is why the ability to leverage the seller’s goodwill to establish proper deal terms that create a shared risk, shared reward scenario become important.
DEAL STRUCTURE: SELLER FINANCING
The most common payment structure for the sale or acquisition of a financial services business typically includes two elements: a cash down payment of about one-third of the agreed upon purchase price, and a seller-financed promissory note for the balance, paid on average over five years at a 5% interest rate. Over the past 20 years, FP Transitions has observed thousands of buyers and sellers use this type of deal structure to create a shared risk, shared reward model.
2018 Average Deal Structure (click to enlarge)
The basic premise of this deal structure is that if the seller successfully transitions a majority of the client accounts to the buyer, then they should receive the full agreed-upon price. However, if the seller fails to deliver a significant portion of the client accounts, the price should be adjusted to reflect what actually transferred to the buyer. The most effective way to account for this uncertainty is through a properly structured performance-based note.
Typically, these notes include a one-time “look-back” tied to the expiration date of the seller’s consulting agreement to provide post-closing transition assistance. From the seller’s point of view, performance-based notes are predictable and carry a reasonable interest rate on the balance with a “lock-in” at the end of the seller’s consulting duties. From the buyer’s point of view, downside protection is provided should the anticipated cash flow from the client relationships not materialize.
Performance-based promissory notes can be structured in a variety of ways but in most cases have a buffer built in that contemplates the effect of market fluctuations—losses of 2-3% of the cash flow post-closing—that may not be enough to trigger an adjustment to the note value. Whereas, a loss of 15% of the clients assets, for whatever reason, would almost certainly cause an adjustment to the final value.
To mitigate risk from the seller’s perspective, when the deal allows for a performance-based adjustment post-closing, it is imperative that the seller perform due diligence on the buyer. Due diligence is more than a background or credit check; it also involves interviews to determine if the buyer’s personality and office culture are going to be a good fit for the clients and seller’s team, if they intend to join buyer’s team post-sale. If the seller isn’t comfortable with the buyer for whatever reason, the likelihood that the deal will close is reduced and the risk of a downward purchase price adjustment is increased.
Once the seller has determined there is a good personality and culture fit, well-prepared documents can help further mitigate risk. Proper documentation will create binding obligations for the buyer, and will clearly state the penalties if the obligations are not upheld. For example, FP Transitions suggests that, in deals with potential downward adjustments, the contracts impose certain restrictions on the buyer until the end of the adjustment measurement period. These restrictions often include changing broker-dealer or custodian affiliation, increasing fees or commissions, and office relocation.
DEAL STRUCTURE: BANK FINANCING
Bank financing has become a more readily available option for buyers to acquire in the M&A space. Before bank financing was available to buyers in this industry, seller financing was previously born out of necessity and created an “economic marriage” between the buyer and seller. It created an incentive for the seller to ensure successful transition of the majority of the client accounts and protected the buyer in the event the accounts did not transfer or in the event of significant change in the market that was beyond their control. As lenders, sellers were allowing the buyer to spread payments over a five-year period on average, charging approximately 4% to 5% interest on average. Comparatively, banks were offering buyers the ability to stretch payments over seven to ten years at a rate slightly higher than what sellers were charging. As such, we have observed an increase in buyers electing to use bank financing, albeit bank financing tends to ebb and flow with the rise and fall of interest rates.
However, buyers understand the importance of creating an incentive for the seller to successfully transition their client relationships. To this end, even when a buyer finances the deal through the bank, we rarely observe true, 100% non-refundable cash payments being made at closing. Typically, buyers are willing to pay up to 70% cash at closing and will escrow or have the seller carry a subordinated note on the balance.
While there are benefits and drawbacks to both bank and seller financing, both deal structures contain several core components:
• The seller’s agreement to provide post-closing consulting to help transition the client relationships;
• The seller’s agreement to not compete, solicit, or accept the client relationships;
• A financial incentive for the seller to successfully transition the client relationships; and
• A financial benefit to the buyer allowing them to make payments over time.
We have not seen a significant difference in purchase price when comparing seller- and bank-financed deals. However, for true cash deals, where 100% of the purchase is paid as a non-refundable cash payment at closing (a rare event in this space), we usually see a sizable discount on the purchase price. The discount here is typically because these types of transactions only include two of the four aforementioned elements:
• The seller’s agreement to provide post-closing consulting to help transition the client relationships; and
• The seller’s agreement to not compete, solicit, or accept the client relationships.
In an asset-based sale, there are three common classes of assets: (1) the client goodwill; (2) the seller’s consulting agreement—i.e. agreement to help transition the client relationships to the buyer; and (3) the seller’s agreement to not compete with the buyer or solicit or accept business from the client relationships that have been transitioned from seller to buyer. The tax allocation of the purchase price with respect to these types of assets adds to the shared reward for both buyers and sellers.
The sale of goodwill—on average 92% of the purchase price—is predominantly taxed at long-term capital gains rates for the seller and is considered an intangible asset to the buyer that can be amortized over 15 years. The remaining 8% is typically allocated between the seller’s consulting agreement to provide post-closing transition assistance (on average 6% of the purchase price) and the seller’s agreement to not compete with the buyer or solicit or accept business from the client relationships post-closing (on average 2% of the purchase price). Table 9.2 outlines how the three common classes of assets are reported for tax purposes and the benefit of such treatment from both the buyer’s and seller’s perspective.
One of most commonly ignored benefits of the tax treatment of the purchase price is the compensation for the seller’s post-closing consulting. This is a service provided by the seller, and as such is expensed by the buyer in the year that it is paid. This means that if a buyer pays one-third of the purchase price at closing, they can offset a portion of the down payment by expensing the following:
• The portion of the purchase price allocated to the seller’s post-closing consulting, which is typically paid to the seller in advance of the performance of the seller’s consulting duties; and
• The pro-rated amount of 1/15th of the acquired goodwill.
Though every deal is different, it is important that both buyer and seller understand each other’s expectations in addition to the common components, tax considerations, and financing options for structuring the sale of a financial services business.