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Buying a Business: Tips for Protecting Your Investment

Buying a successful business is still the best way to leave the rat race and write your own ticket. But it's not without risk. One major risk is underperformance. The best way to set your purchase price is by reviewing the business’s past performance.

Problem is, if business declines—whether due to faulty data or other factors like economic downturn—you could end up in a tight spot. Luckily, there are powerful deal techniques to protect you while offering upside growth. Today, I’ll share how to structure them, when to use them, and how to convince sellers to agree.

Why Don’t More Buyers Use Protective Techniques?

Many buyers shy away from these techniques. Why? Four main reasons:

• Didn’t know about them.
• Worried it makes them less competitive.
• Unsure how to convince sellers.
• Don’t know they’re SBA-compliant.

Don’t worry. These techniques are 100% SBA-compliant (though some lenders may have their own guidelines).

Hypothetical Deal

Roofing contractor in Texas.

Historic financials:

• 2021: $3.8M Rev, $700K SDE
• 2022: $4.1M Rev, $780K SDE
• 2023: $6.0M Rev, $1.2M SDE

Listed price: $3.5M

YTD 2024 financials are trending to meet or beat 2023. The business is highly dependent on weather and constrained by supply-chain and labor. It’s the largest roofing contractor in the region with both residential and commercial clients.

You see potential but worry 2023 was an anomaly (post-COVID bump) and future profitability might decline.

Step 1: Consider the Seller’s Motivations

Before diving into techniques, keep the seller’s interests in mind:

1. Will I get my purchase price?
2. How much cash at close?
3. How certain is the deal to close?
4. How quickly will the deal close?

Understanding these will help you structure and communicate your protective techniques without offending the seller.

Step 2: Protective Techniques

1. Forgivable Seller Note

A forgivable seller note is a portion of the seller note that’s subject to permanent forgiveness if the business underperforms. It requires:

1. Review Dates (e.g., 12 and 24 months after Close).
2. Performance Benchmark (e.g., Gross Revenue).
3. Measure of Actual Performance (e.g., YTD Gross Revenue).
4. Forgiveness Structure (e.g., a ceiling where nothing is forgiven, a floor for full forgiveness, and tiers in between).

Example:

• $350K Seller Note.
• Benchmark = 2023 Gross Revenue ($6.0M).
• Review Date = 12 months after Close.
• Forgiveness: If TTM Gross Revenue meets/exceeds $6.0M, no forgiveness. If it falls below $5.4M, 100% forgiven. Between $5.4M and $6.0M, 1% is forgiven for every $6 in shortfall.

Summary:

• Forgives part of Seller Note for failing to meet historic performance.
• Can be acceptable if framed as necessary for a full price offer.
• Sellers may be wary since payout depends on your management post-closing.

2. Seller Note with Revenue Stabilization

For sellers who balk at forgiveness, use a repayment “pause” or “full standby” for revenue stabilization. Conduct Revenue Reviews every 6 months for 2 years. If TTM Gross Revenue drops below a threshold (e.g., 5-10% below Benchmark), the note goes on full standby for 6 months.

Example:

• $350K Seller Note.
• Benchmark = 2023 Gross Revenue ($6.0M).
• Review Dates = every 6 months for 24 months.
• If Actual Performance is 5% below $6.0M, the note goes into full standby for 6 months.

Summary:

• No forgiveness, just delay in repayment.
• Limited duration of protection.
• More attractive to sellers since they eventually get paid.

3. Performance Escrow

A performance escrow sets aside part of the purchase price with a third-party escrow agent. Funds are released based on performance metrics.

Example:

• $400K Performance Escrow.
• Benchmark = 2023 Gross Revenue ($6.0M).
• Review Dates = every 6 months for 24 months.
• If Actual Performance meets/exceeds Benchmark, $100K is paid to the seller. If not, $100K is rebated to the lender.

Summary:

• Attractive to sellers since they get money sooner.
• Less attractive to buyers since money must be escrowed.

Step 3: Bringing it All Together

You now have three techniques to mitigate downside performance:

1. Forgivable Seller Note.
2. Seller Note with Revenue Stabilization.
3. Performance Escrow.

You can mix and match these techniques based on your risk appetite and deal specifics. Understanding these techniques helps you structure better deals, ensuring your financial interests are protected post-closing.

Questions? Send me an email or join in the convo on X (@lawyer4SMBs).

Otherwise, happy hunting!

Eric Hsu, M&A Lawyer

Publisher, Freedom through Acquisition Newsletter

DISCLAIMER:

I am a lawyer but not your lawyer (unless we so happen to be working a deal together pursuant to a written engagement agreement). This newsletter is for educational and informational purposes only and nothing in this or any other issues is intended as legal or financial advice and cannot be relied on as such. Do your own diligence and consult with your own lawyer or financial advisor before taking any action on your deals. Nothing in this newsletter is intended to solicit your business in any way and should not be interpreted in any way as legal advertising.

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