Club Broker H. Winston Hines provides key details on what, exactly, “owner-financed deals” are, how they work, and why they shouldn’t be dismissed or overlooked.
(Note: This story appears in the September 2023 issue of ED Magazine)
I
’m a 31-year licensed commercial Real Estate Broker; a Certified Business Intermediary (CBI) through the IBBA (International Business Brokers Association) for over 20 years; and a niche market specialist in the sale, purchase or valuation of adult nightclubs and bookstores across the US and Canada. That being said, when I answer the phone, and someone on the other end starts out by saying, “I’ve got great credit at my local bank…we ain’t gonna have no problems getting this deal financed…” or even worse, “I’m planning on getting an SBA loan…blah, blah, yada yada,” of course, I have to bear the bad news that 99.9% of the banks in the US will not finance in any way, shape or form anything that has the word “adult” in its description. But we all know better, don’t we? The seller, and therefore, that buyer, do have some alternatives:
The Cash-Out: The easiest arrangement possible, and a lot of times, at a discount to the asking price just to get the deal done.
The Earn-Out: In recent years, as lenders have become more and more difficult to deal with, the earn-out has evolved on two different forms I’ll mention, but not go into detail, here. In one scenario, the seller accepts a lower sale price at the closing, with the proviso that over a designated period of time, if certain sales or earnings levels are met or exceeded by the buyer, then the buyer pays a percentage or negotiated difference also to the seller. It does work to bridge a deal where the gap between seller’s price and buyer’s price is just too hard to overcome, but it also requires a heavy element of trust and oversight on both parties to make the deal work. The other aptly-named earn-out scenario is one where buyer buys into a percentage, say 25-49% of the operation, and then works as the active, working partner over a course of time to earn or buyout the balance of the ownership of the club, usually on some sort of negotiated time frame. This works great for general managers who are looking to step up and into ownership, but do not necessarily have the cash upfront to take down the entire deal. Of course, this kind of deal also works great for that entry-level first-time buyer who is willing to put sweat equity into the deal and who may not have the needed skill set or experience, or maybe the ready assets, to do the deal.
Now we come to heart of most adult club sales: Owner financing, sometimes called “seller financing,” and more definitively called a “private mortgage.”
Advantages: It is a private transaction: There is no reporting to the credit bureaus and fairly limited governmental reporting. It involves a lot less people (translate, less cost) to close. One key salient point: It does not affect the credit report of the buyer. His or her buying power remains unchanged. There are tax advantages for the seller in not receiving all the sale proceeds immediately. The seller (soon to be former owner) usually receives interest on the balance financed over whatever period of time agreed upon. This can be a sizeable figure in addition to the sale price itself. There are several other aspects of an owner-financed deal that work well…just ask me at the ED EXPO, Booth 31.
Disadvantages: The seller has suddenly become, in other words, the lender. They have taken on all this risk that this deal will never have any glitches in it, that the buyer, as now known as the mortgager, will always pay on time, and never fail to pay, and never, ever, get into any kind of trouble….or else (hmmm!). And if there are any problems, it will be up to the seller on their own dime to engage an attorney for probably time-consuming, costly and mentally-demanding litigation to reassert control and/or ownership and wade through the mess that the buyer has made of this deal. In the worst instance, a buyer can manage to fuck up so completely that they lose the adult-use license for that location, thereby forever screwing the seller from being able to reopen under their own control or to sell it again as an adult-use location —it happens!
This is why a lot of owner/sellers say “Fuck it! Cash only, no owner-financing.” They are absolutely right to do so. Of course there is always the worst-case scenario…but here is why, where and how a good solid owner-financed deal can and will benefit both parties. Attorneys or escrow agents for a closing are going to draw up four basic documents for the closing on an owner-financed sale of your club:
1) The formal purchase agreement: It will already be in place and will be the document that guides or directs to the completion of the closing.
2) The promissory note: A promissory note is a document that designs a repayment obligation on the person who is buying the club. Basically, the buyer/promissor promises to repay the money at a certain point in time, with a certain amount of interest and according to an agreed-upon repayment time-line. The promissory note essentially implements the repayment obligation generally referenced in the purchase agreement.
3) The personal guarantee: A document that an attorney may want to require as part of a private lending transaction is a personal guarantee. A personal guarantee describes a repayment obligation on somebody other than just the business entity defined in the promissory note. For example, if the borrower under the promissory note is a business entity, the seller may require a personal guarantee from the individual owner of that business entity.
4) The security agreement: It is always better to implement a security agreement as a part of the loan transaction. The security agreement identifies property, or even other assets of the buyer, if real estate is involved as collateral or collateralization of the business, in the event that the buyer is unable or unwilling to repay the owner-financed balance subject to the terms of the promissory note. Breach of the promissory note starts the seller’s rights under the security agreement to go after and repossess the business and/or real estate.
That is the basic body of documents of a private owner-financed transaction. But there are some elements that will make it easier for the buyer to convince the owner to part with their club and the seller to be more comfortable with owner-financing:
1) The seller needs to engage a CBI broker, not a CPA, to recast those income and expense numbers to develop as solid as possible a snapshot of the cashflow of that club — in other words, to be able to show both the seller and the buyer that the buyer will be able to make those payments to the seller based on the historical cash flow. These various financial tests will tell both seller and buyer how safe that deal is. The most important test for our purposes here is called the DSCR, or debt service coverage ratio, which tells the seller, and buyer, how much money — after ordinary expenses — should be available to repay the monthly debt service. Banks (and a seller, also) should like to look at a 1.2 or higher ratio. This is a quick, down-and-dirty test that lets both parties know exactly how well cash flow per month will stand up to the monthly payment.
2) The personal guarantee is essential to have in place besides the corporate guarantee, and every buyer partner needs to be on the hook as well.
3) The security agreement needs to have requirements to report the status of the operation, should there be litigation or legal issues that might, I repeat, might, impact the ability of the buyer to repay.
4) Last, but sure as hell not least, if state law allows where your deal is being done, seller’s attorney should attempt to apply a cognovit agreement in addition to the regular security agreement. A cognovit agreement is a promissory note or a confession of judgment that permits judgment to be entered without a trial for the purpose of saving an awful lot of legal costs. To apply a cognovit agreement, the buyer authorizes the entry of judgment against themselves in the event of their breach or default, by inserting a cognovit provision in an agreement. This is a promissory note with teeth! I discovered it in a deal in Ohio, but have since discovered that it can be applied in a number of states. I cannot emphasize enough the strength of this clause. Just remember, not every state allows cognovit agreements, and where accepted, there has to be specific and in bold print just what the buyer is agreeing to allow to happen if he or she fails to repay.
I am not an attorney; I am a broker. The above information should be handed off to your individual attorney when you are contemplating the sale of your club.
There is a lot more to cover, such as defining the value of real estate versus the ongoing business value, and how costs are allocated, but for right now: Have a great EXPO, and I look forward to meeting you at Booth 31!
Winston Hines, Broker in Charge of HWH Properties, is a licensed commercial Real Estate and Business Broker, specializing in the purchase and sale of adult nightclubs throughout the U.S. for almost 20 years. He is a member of the International Business Brokers Association (IBBA) and American Business Brokers Association (ABBA). He holds a Certified Business Intermediary (CBI) designation, as well as an (ABI). He can be contacted at either (864) 580-3826 or updaze@aol.com.
