When Buying a Troubled Business, Consider a Royalty Deal

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Posted: Feb 16, 2016 12:01 AM
When Buying a Troubled Business, Consider a Royalty Deal

"I have an opportunity to buy a service business in my area.

"The business has been run forever by a gentleman who is now 88 years old. He has run the business very informally over the years, with several employees who have become "family" (his daughter, not a professional accountant, has been keeping the books).

"We have looked at his books and tax returns for the past several years, and are convinced there have been no serious compliance problems. But we do notice that the business has seen declining sales over the past couple of years, probably due to the fact that the owner is tired and can no longer devote the time and energy necessary to market this business aggressively.

"Marketing just happens to be my strength, and I think I can turn this business around in the next year or two. If I'm wrong, though -- if the decline in sales is due to something more serious than the current owner slowing down -- I don't want to overpay for the business.

"I would like to make an offer to the owner, who is quite anxious to turn the business over to someone else, but don't know where to begin. What should I do?"

OK, there are two observations I would make upfront:

--The business' current owner is 88 years old.

--This is a personal business closely identified with the owner, so you will need his cooperation in dealing with customers and transitioning the business over at least the next several months.

You could offer to work in the business for a year or two, as director of marketing, so you could learn the business and increase revenue enough so that you could pay a fair price for the business in the future. The problem with that approach is the owner's age -- there is a significantly possibility he will die or become permanently disabled in the next couple of years, leaving you to negotiate the purchase price for the business and other details with his heirs, who may or may not be cooperative.

Another problem is that if the business is experiencing a decline in sales, there may not be enough cash flow to pay you a decent salary during the period you will be employed.

There is another possible solution to this dilemma, which you should discuss with the owner and his advisors. It's called a royalty deal, and here's how it would work.

The company's accountant would first determine the liquidation value of this business -- what the owner would get if he shut the business down, paid off all the debts (if any), and sold all of the business assets. For a service business this should be a relatively small amount: Just as an example, let's say it's $20,000.

You would then offer to purchase the assets of this business (not the stock in the owner's company) for a reasonable purchase price based on the last couple of years' earnings. Just as an example, let's say you settle on $150,000 as the target purchase price. You would pay the liquidation value ($20,000) as a down payment for the assets, and pay the $130,000 balance in the form of a royalty on gross sales over the next one to three years (no longer than that, in light of the seller's age). Each month or quarter, you would determine the gross sales of the business and pay the owner a royalty of 10 percent to 20 percent of that amount. Each royalty payment would be credited against the balance of the purchase price until it is paid in full (perhaps with interest at the lowest federal rate, currently about 2 percent per annum).

Once the seller has received the targeted purchase price ($150,000), with interest, you would no longer owe anything to the seller. If the targeted purchase price is not paid in full at the end of the agreed upon time period, then one of three things would happen:

--You would pay the remaining balance in full, plus any accrued interest.

--The remaining balance would be forgiven in its entirety.

--The remaining balance would be termed out and paid in equal monthly installments over the next two to three years.

Which option you choose would depend on the performance of the business at that time.

By doing a royalty deal, you give yourself enough time to figure out where the bodies are buried and turn the business around. You also incentivize the seller to hang around and work with you to make sure the business doesn't deteriorate further -- his success is directly tied to your own.

Just keep in mind that if the business fails to turn around and you choose the "forgiveness" option, you will have to report the amount forgiven as income on the business' tax return in the year in which the debt is forgiven.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

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