The ABCs of IOUs

Most financial advisors would prefer to sell their practice to their junior associate or associates. Yet in-house deals are notoriously hard to put together. For one thing, it’s often difficult for young advisors to come up with the purchase price, or even a reasonable down payment. These buyers are reluctant to borrow funds for the purchase and be cash poor for the foreseeable future. For another, the sellers frequently don’t want to self-finance the purchase, especially in arrangements that enable the buyers to buy the practice out of cash flow.

The reality is that even in sales to outside buyers, very few practice purchases are made for all cash: somehow, some way, the acquisition price is financed. By understanding the financing options, and structuring a deal that’s right for both parties, many in-house sales can work to the great mutual benefit of everyone involved.

What are the financing options? Bank loans, Employee Stock Ownership Plans (ESOPs), private capital, promissory notes, and earn-outs tend to be the instruments in the toolbox. Seller financing in the form of a promissory note or earn-out tends to be the least expensive source of capital for the borrower. Due to tax advantages for the seller and the required valuations, ESOPs can be a reasonable alternative. Bank loans may be more expensive, due to higher interest rates that reflect risk, as is SBA financing, since there’s an additional fee paid by the borrower to cover the extra paperwork involved in dealing with the government. Private equity is the most expensive of all because investors are eager for their pound of flesh and often want it from top-line revenues for an extended period. Here’s how each financing source can help you create the right package for a workable in-house sale.

Conventional Bank Loans

Almost everyone involved in mergers and sales of smaller advisory practices complains about the difficulty of getting bank financing. For years, broker/dealers and custodians have tried to find an outsourced solution, but few banks see the market as big enough to commit resources to understand the industry. One bank–Midwest Bankers in Indianapolis (midwestbankers.com)–is an online lender that has grown through financing sales of other professional practices and has been developing expertise in the financial advisory world. They have an efficient, scaleable model that could work well in this marketplace.

Typically, a buyer puts down 20% of the practice value, a bank provides financing on another 30%, and the seller finances the remaining 50%, either through an earn-out or promissory note. These percentages can vary, of course, depending on a variety of factors, such as the financial strength of the buyer, and the earning capacity and valuation of the business.

In almost all cases, a buyer will need to provide a personal guarantee on the loan, meaning they could be putting their home at risk if they don’t have other assets to back up the repayment. In other businesses, such as manufacturing or real estate development, there would be tangible assets to collateralize–unfortunately, such assets rarely exist in an advisory practice. Some will argue that there is value in the client base, but this is not a readily transferable asset and requires that somebody manage the relationships for it to work.

SBA Financing

We are aware of a few cases in which buyers have obtained loans through a Small Business Administration (SBA) program (sba.gov/financing). These are variations on conventional bank loans, with one crucial difference: The federal government will back the bank so that small business owners can get credit. The standards may or may not be as rigorous when accessing an SBA package, but the government’s backing often helps banks to make the loan.

In most instances, banks use credit scoring tools like Fair Isaacs to evaluate the credit worthiness of the borrower and of the business based on credit histories and sources for repayment–typically their assets. When the borrower does not meet the minimum credit score, bankers can require the seller to co-sign the loan and/or provide personal guarantees.

Private Financing

Buying practices is a time when banks make us appreciate our parents–especially ones with the resources to underwrite the transaction. If sellers require a substantial amount of cash, buyers often have to find help to make this happen.

Strangers also can be a good source of capital for purchases, although perhaps more expensive. Many private sources will require an equity position, or preferred right to take equity in lieu of interest payment–in the belief that they’ll make their return upon a future sale. One of the more intriguing private equity sources is Asset Management Finance (AMF), a firm founded by Norton Reamer, who also founded United Asset Management. According to Reamer, AMF provides financing for liquidity and diversification needs of principals; generational transfers of ownership; spin-offs from parent companies and acquisitions of professional teams or blocks of business.

AMF uses a proprietary device called Revenue Share Interests (RSI) in which they exchange upfront capital for a fixed percentage of a company’s gross revenues for a defined period of time (anywhere between seven and 20 years). The people running the firm never give up control, and at the end of the period, AMF is out of the picture. AMF is primarily focused on asset managers but has an interest in all providers of financial services, as long as the economics are sound.