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. In an asset-based sale, both buyer and seller receive more favorable tax treatment when compared to a stock sale. Since financial services businesses are primarily relationship-based, providing mostly intangible services, what is being sold in an asset sale is rights to a future benefit stream—namely, revenues. However, given the intangible nature of the assets, there is no certainty that a buyer will receive the same amount of revenue from the clients as the seller did. This is why the ability to leverage the seller’s goodwill (the primary asset being bought and sold) 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 he or she 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, as opposed to an arbitrary discount to the value. Combining a discounted purchase price along with a performance-based note may amplify the buyer’s discount, shifting more risk to the seller.
To mitigate risk from the buyer’s perspective, buyers prefer to use an adjustable, performance-based promissory 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 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 5–7% 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 if the clients are likely to stay on with the new advisor. 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
Up until about three years ago, financing arrangements in the financial services mergers and acquisitions (M&A) space were strictly between the buyer and the seller. Slowly, bank financing has become a more readily available option for buyers. When bank financing entered the market, we began to see some changes in the marketplace; more buyers inquired about practices and sellers received larger down payments at closing. Interestingly, even with larger down payments, we have not observed a significant change in pricing multiples.
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 5% interest. Comparatively, banks were offering buyers the ability to stretch payments over 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 over seller financing.
However, buyers understand the importance of creating an incentive for the seller to successfully transition the clients and the goodwill. 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 75% cash at closing and will have the seller carry a subordinated note on the balance. Alternatively, they will pay 100% of the purchase price at closing, but a portion of the purchase price—25% or more—is held in an escrow account until the seller’s post-closing consulting contract has been fulfilled or the majority of the assets have transferred to the buyer.
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 transfer the assets;
- The seller’s agreement to not compete or solicit the clients subject to the purchase agreement;
- A financial incentive for the seller to successfully transition the clients and their goodwill; 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, we usually observe discounts in the range of 15–35%. The increased 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 transfer the assets; and
- The seller’s agreement to not compete or solicit the clients subject to the purchase agreement.
Absent the seller’s financial incentive and ability to finance the purchase price, a buyer will generally expect a discount when paying cash at closing since the buyer has assumed all of the risk.
In an asset-based sale, there are three common classes of assets: (1) the book of business itself; (2) the seller’s consulting agreement—i.e. agreement to help transition the clients to the buyer; and (3) the seller’s agreement to not compete with the 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 assets—on average 85% 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 15% is typically allocated between the seller’s consulting agreement to provide post-closing transition assistance (on average 10% of the purchase price) and the seller’s agreement to not compete or solicit the clients subject to transition (on average 5% of the purchase price). Table 9.2 outlines how the four 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 fee for the seller’s post-closing consulting. This is a service provided by the seller, and as such the consulting fee 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, he or she 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 assistance, paid to seller in advance of the performance of the seller’s consulting duties; and
- The pro-rated amount of 1/15th of the client accounts and seller’s 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.