Smart Play: Seller Financing

Katie Fleming

Katie Fleming

Co-founder and COO of Owner Actions

A seller and a business buyer work through a seller financing arrangement.

Lots of sellers exiting a business are doing so in a smart way. They're selling their business to qualified buyers, and they're offering seller financing that makes the deal even more appealing.

In this article, we'll explain what seller financing is. We'll also help you decide if it's a smart play for your sale.

 

What is seller financing?

Seller financing, sometimes called a seller's note, is a loan that you, the owner of your business, provide to a prospective buyer to cover part of their purchase price.

This loan is similar to one a buyer might take out from a bank. Through it, the buyer will need to make regular payments and pay interest directly to you. You can set the terms, the duration, and the rate of the loan however you choose. But, of course, buyers usually won't take you up on the offer unless it makes good, financial sense to do so.

 

Why would a buyer choose seller financing over another source of financing?

Many buyers seek out SBA loans, bring in partners, and tap into their own savings to afford the purchase price of a business. Seller financing is another resource that they can use to access funding. It’s often requested from buyers who are interested in purchasing higher-quality businesses and building liquidity that can help them cover early operating expenses.

In most cases, seller financing is used as a second form of financing. When this is the case, many choose to use it to help cover loan down payments.

But, sometimes, the terms are seller financing are more favorable than what a buyer can obtain from a bank. Low interest rates, specifically, is a reason many use this source of funding.

 

What’s in it for me?

By offering seller financing, you’re signaling to buyers that you believe in the long-term potential of your business. This show of confidence can attract buyers, fueling the possibility of multiple offers and a higher sales price for your business.

By offering seller financing, you can widen your pool of potential buyers to include excellent buyer candidates who couldn't afford your business without it. With a wider pool of candidates, you can select a buyer who has the skills, experiences, and knowledge that are necessary to run your business, even if they don’t have all the capital they need to cover the upfront costs.

Another key benefit of this arrangement is the ability to earn more money from the sale of your business. Because seller financing is a loan, you can charge the buyer market interest rates on top of the principal price of the business. This should result in a significantly higher payout than you might have earned through the sales price alone.

Finally, seller financing can be a smart tax play. Depending on the terms of your arrangement, you could structure your sale so that you receive incremental payments over a span of years rather than a single lump sum. These smaller yearly payment amounts, reportable as capital gains, could help you achieve significant tax savings by realizing gains at lower tax rates.

Speak with a professional accountant to learn how you might benefit from this arrangement.

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Is this a smart play?

It can be, provided that you take several important steps. Just like a bank would run a thorough check on a loan applicant, you should investigate your buyer’s creditworthiness, financial qualifications, background, and reasons for wanting to take on debt to buy your business. You should never offer seller financing without running a credit check or reviewing the buyer or buyer entity’s financials.

You should also make sure that a lawyer is involved in any seller financing terms you arrange. Together, you should set clear, enforceable terms that spell out your right to reclaim control of the business in the event of default and the courses of action you’ll be entitled to pursue for missed loan payments.

 

Here's something important to note. You may not have first claim to the business’s assets in the event of default. This is often the case when a buyer uses multiple sources of financing to cover the purchase of the business. Generally, bank loans include terms that grant them first claims to the business’s assets. After those entities recoup their losses, subordinate lenders, like you, will be able to claim what remains. Sometimes, it may be nothing.

Because of this risk, you should talk with a lawyer before agreeing to a seller financing arrangement. Click the Connect button to speak with one who is experienced in small business sales terms:

 

How soon can I begin to receive repayments?

It depends on the terms you set and whether the buyer is using an SBA loan to finance a portion of the business.

When buyers apply for an SBA loan, they're often required to make a down payment of at least 10% of the purchase price of the business. Some buyers use a seller’s note to pay for up to half of their down payment, creating the following financing structure:

  • The lender provides financing for 90% of the purchase price of the business.
  • The buyer covers 5% of the price, which goes toward the required down payment.
  • The seller, through a seller’s note, covers the remaining 5% of the price, which is also applied to the required down payment.

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Here's why this is important: Any portion of seller financing that’s applied to the down payment of an SBA loan cannot be repaid to the seller until the full balance of the SBA loan is repaid or the loan is refinanced into a non-SBA loan.

This scenario can be confusing for first-time buyers and sellers. The following example illustrates how it works:

 

Ann is a buyer who has committed to paying $500,000 for the purchase of a business. The seller, Steve, has agreed to provide seller financing up to $25,000, or 5% of the price of the business. Ann also has cash that she plans to apply to the purchase, and she has decided to apply for an SBA loan to cover the balance of the purchase price.

 

Before proceeding, Ann must choose one of the following options:

    1. She can apply the seller’s note toward the $50,000 down payment the SBA requires to finance the business. Steve’s seller’s note will cover half of the down payment, and Ann will need to come up with the remaining $25,000 for the remainder of the down payment.

 

When is the seller repaid? Steve would not be eligible for repayment until Ann has either repaid the entire balance of the SBA loan or refinanced the balance into a non-SBA loan option.

 

    1. She can choose to subtract Steve’s $25,000 seller financing from the price of the business before applying for another loan. In this scenario, Ann would apply for a $475,000 loan to cover the $500,000 business. She would need to come up with $47,500 of money that isn’t Steve’s to cover the down payment.

 

When is the seller repaid? Steve could begin receiving repayments from Ann immediately because no part of the seller’s financing was included in the down payment.

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The key takeaway is that buyers can repay any seller financing that’s not applied to the down payment of the SBA loan at any time, following the terms that the buyer and seller set.

 

Why would a buyer use my financing for a down payment?

Seller financing that covers up to half of a buyer’s down payment enables the buyer to afford a significantly higher-priced business. Consider the following example:

 

Don plans to buy a business. He has $50,000 in cash to use for a down payment and plans to take out an SBA loan to cover the rest of the costs. The SBA loans he's considering require at least a 10% down payment, so without another source of financing, the highest price Don can pay for a business is $500,000.

If he can find a seller who will loan cover half of the 10% down payment, or 5% of the total price of the business, Don’s $50,000 could stretch further. He would only need to cover the remaining 5% of the down payment. If he applies his full $50,000 to this requirement, he could afford a business that’s priced at $1,000,000.

 

Can I request that my note isn’t used for a down payment?

You can set up the terms of your financing however you see fit. Ask your attorney to help you draft a contract that states your requirements.

 

What terms should I set?

In the following graphic, you’ll find some general terms many sellers use when structuring their loans. While these terms may be useful for understanding your buyers’ expectations, you should work with an attorney to set terms that reflect your goals and preferences.

Most sellers offer loans between 10-15% of the purchase price, but loan amounts up to 40% are not unusual. Few sellers lend more than 40% of the purchase price.

Most sellers agree to a payback period of 5-7 years to allow new owners time to work through the transition and ramp up before their full payment is due.

Many sellers mirror the interest rates that are offered by competitive financial institutions. By matching or coming in slightly lower than market loan rates, sellers can position their funding as an attractive option for buyers.

What should I do next?

Decide if seller financing is something that you’re interested in pursuing. Your accountant, attorney, and broker (if you choose to use one) will help you weigh the pros and cons of seller financing, and they’ll be able to help you structure your loan to afford you some protection against default.

Need help finding an accountant, an attorney, or a broker? Start by reading the following guides:

 

Then, use the search tool at the bottom of the page to with experienced professionals in your area.

 

Access more free advice, articles, and step-by-step guides that will help you sell your business by logging into your owner’s portal.

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