Seller Financing

The vast majority of small business sales – 80%, according to industry statistics – include some form of seller financing. Most M&A transactions in the middle market contain some component of seller financing but the amounts are low – often 10% to 40% of the transaction size. 

Seller financing is often the most suitable option if SBA financing can’t be obtained. Seller financing is also faster to arrange and requires less paperwork than traditional financing sources. 

One of the first questions buyers have is whether you will finance a portion of the sale.

Deciding To Offer Seller Financing

Decide early in the process of marketing your business whether you will offer seller financing. This is because one of the most important components of the business sale is how the buyer plans to finance the transaction. One of the first questions buyers have is whether you will finance a portion of the sale. With seller financing, you receive a down payment and then periodic, usually monthly, payments until the buyer pays you in full.

For example, if the purchase price is $5 million and you’re willing to finance 50% of the purchase price, the buyer puts down $2.5 million and makes monthly payments on the remainder until the balance of the seller note is paid in full.

Because you are functioning as a bank, you should ask your accountant to assist you in pre-qualifying the buyer before committing to financing the sale. You may pre-qualify the buyer by obtaining a copy of their credit report, a resume detailing the buyer’s previous business experience, and, in some cases, even hiring a private investigator. The buyer may also offer their personal assets as collateral, in addition to the assets of the business.

Most sellers of small businesses want a minimum down payment of 50%, and most sellers offer terms ranging from three to five years; but, the terms must make sense financially for both parties involved.

For middle-market businesses, these deal structures usually include a seller note amounting to 10% to 40% of the purchase price with an amortization period from two to four years.

You should consider the following to protect yourself:

• Require that the buyer meet certain specifications or financial benchmarks after closing, such as maintaining a minimum amount of working capital or inventory. 
• Request access to financial statements during the term of the loan so you can identify and address problems early on.
• Remain on the lease during the duration of the note.

Benefits of Financing the Sale

For small businesses, it’s best to offer specific terms when marketing your business for sale. This sends the message to the buyer that you have given the sale careful consideration, and are serious and realistic in terms of the sale. Buyers like to deal with realistic and prepared sellers. You will also receive more responses if you market your business for sale with some form of financing versus for all cash.

For mid-sized businesses, it’s common to market a business without a price and without offering specific terms. Here are a few additional benefits to financing the sale:

• Higher Selling Price: Businesses that include seller financing sell for 20% to 30% more than businesses that sell for all cash.
• Lower Taxes: You generally don’t pay taxes until you receive the money, but there are always exceptions when it comes to tax law. Be sure that the note is structured so it’s “non-negotiable” to avoid having to pay income taxes until you receive the money.
• Faster Sale: Businesses offered with seller financing are easier to sell than a business offered for all cash.

What if you will finance the right buyer?

In this case, I recommend mentioning that financing is negotiable. Don’t specify the exact terms under which you would finance the sale. This doesn’t commit you to financing the sale; however, the mention of possible financing invites buyers who are only looking at businesses in which the seller would finance a portion of the deal.

Can you sell the note if you need cash?

You can often sell the note after it has matured for 6 to 12 months. There are many investors who purchase these notes, which effectively cashes you out. Unfortunately, it’s often at a steep discount, but there are few alternatives other than selling your note. If you would like to leave this option open, it’s important to ensure that the note can be transferred or assigned to a third party.

Terms

What interest rate is fair to charge?

The rate depends on the amount of risk involved and less on the current cost of money. Over the past 10 years, the interest rates charged on promissory notes have ranged from 6% to 8%. 

Some buyers state that current interest rates on residential real estate mortgages are much lower and that the rate should be competitive with these. As I explain to buyers, such a loan is risky for the seller and little collateral is available, other than the undervalued assets of the business. If you default on your mortgage, the bank simply takes your house. However, if you default on a loan used to buy a small business, there often isn’t anything to take back other than a struggling business.

Other factors that should be considered in determining the interest rate to charge include the total price of your business, the buyer’s credit score, the buyer’s experience, the buyer’s financial position, and perhaps most important, the amount of the down payment. The interest rate is more a function of the risk than the current cost of money.

How do you determine how much to finance?

Your decision regarding how much to finance must make sense from a cash-flow standpoint – if your business makes a profit of $100,000 per month, then a note of $90,000 per month won’t make sense. The profit from your business must cover the amount of the note and also pay the buyer a living wage. If it can’t, then it won’t work.

The following information is based on statistics from more than 10,000 business sales:

• Average Interest Rate: Ranges from 6% to 8%, but there’s a slight variance. This is based on risk, not prevailing interest rates. Financing a business is risky, leading to relatively high rates compared with interest rates on other assets.
• Average Length of Note: Five years, but it varies from three to seven years. 
• Average Down Payment: Usually 50%, but it varies from 30% to 80%. 
• All Cash Deals: Less than 10% of businesses sell for all cash.

How many years should the note be for? 

Most notes range from three to five years. But common sense is the rule of thumb here. The cash flow from the business should cover the debt service. 

Let’s look at a simple case that doesn’t work because the debt service is too high:

Price of Business:	$1,000,000
Down Payment:	$300,000
Amount Financed:	$700,000
Term:	2 years
Interest Rate:	8%
Monthly Payment:	$31,659/month
Annual Payment:	$379,908
Annual Cash Flow from Business:	$400,000
Minus Annual Debt Service:	$379,908
Profit After Debt Service:	$20,092

This scenario won’t work because the payment is 94% of the annual profit of the business. A more realistic scenario would be a four-to-five-year term. Note that the term has a bigger impact on the amount of the payments than the interest rate. The payment should be less than a third of the annual cash flow of the business. If the cash flow of the business is stable from year to year, then it can be higher. If the cash flow is inconsistent, you should build in a cushion and structure the note so the payment is lower.

Should you hire a private investigator?

If you are considering financing a significant portion of the purchase price and doubt the buyer’s credibility, you need to protect yourself. Money spent on an investigation could save you hundreds of thousands of dollars down the line if you find out that your prospective buyer is a bad credit risk.

A private investigator can reveal information about individuals who want to purchase your business, such as aliases and undisclosed addresses. This information can help you determine the character of your buyer’s past and their creditworthiness.

In addition, a private investigator can help you learn if the potential buyer has any current or previous litigation, debts, or claims that could predict whether they would default on the loan to you. An investigation of their public records could help identify any undisclosed arrest records, bankruptcies, corporate records, court records, criminal records, deeds, or divorce filings.

It’s important to note that a signed release may be required by law to obtain this information. The buyer has a right to refuse the release, though they should understand your need to protect yourself if they’re asking you to finance the loan. Explain to the potential buyer that it’s a necessary action, considering the financial risk you are taking. They would have to do the same thing with a bank or financial institution. You should also consult your attorney for more advice.

Documenting and Managing the Note

There are specific documents involved in seller financing that need to be drafted. You will need a promissory note and security agreement that address the key terms of the seller note. When you are financing the sale of your business, your note is secured with a Uniform Commercial Code (UCC) lien on the assets of the business. This UCC-1 lien should be filed post-closing with your local county or state. 

The UCC lien prevents the buyer from selling the business or the assets during the term of the note. It’s also protected with a promissory note and a personal guarantee. If you hire a broker to sell your business, the broker will usually draft these documents.

Why should you use a third-party loan processor?

I recommend using a third party to service the loan for a number of reasons. A loan processor handles all aspects of collecting, crediting, and disbursing monthly loan payments. As a neutral third party, they simplify the day-to-day management and process of managing loan payments. Using a third party to administer the payments simplifies recordkeeping.

Using a third party also removes your obligation to handle late payments, freeing you up to focus on more important matters. It also allows you to maintain a good working relationship with the buyer by having an independent third party serve as a buffer if payments arrive late.

Preventing and Resolving a Default 

Because you are financing a portion of the sale, you need to think and act like a bank, and qualify the buyer before committing to financing the sale. I recommend obtaining a detailed financial statement, credit report, resume, and any other pertinent information you can get from the buyer as early as possible in the process. You should also select a buyer you think will succeed in your business from an operational standpoint.

If the buyer of your business is another company, ask the buyer about their previous acquisitions. Talking to the owners of companies they have acquired in the past may also be helpful. Depending on the size of the company, it may be prudent to perform due diligence on the principals of the company that wants to acquire your business.

Most of the problems I see related to seller financing originate from the seller accepting a low down payment, which would be anything less than 30%. I suggest asking for a down payment of at least 30% to 50% of the asking price. Why? Few buyers will walk away from such a large down payment.

If the buyer is an individual, you may also be able to negotiate to collateralize the buyer’s personal assets in addition to the assets of the business; but doing so can sometimes signal to the buyer that you don’t have faith in your business. 

Additionally, you can require the buyer to maintain specific financial benchmarks post-closing, such as maintaining a minimum level of inventory or working capital. I also recommend that you have access to monthly or quarterly financial statements. This should enable you to spot and help correct any problems early on if they do arise.

The vast majority of small business sales – 80%, according to industry statistics – include some form of seller financing.

How common is a default?

I estimate default rates for seller notes to range from 2% to 5%. While no verifiable statistics exist on default rates for seller notes, I believe my estimate to be accurate. The default rates for SBA loans have ranged from approximately 2% to 5% over the previous 10 years. Default rates tend to be the highest for the riskiest industries, such as restaurants and retail. If you think and act like a bank, then you can expect a success rate of 95% to 98%.

If you are concerned that the buyer is going to default, you should first attempt to come to a mutual agreement with the buyer. In many instances, a default by the buyer can be simply and easily dealt with by talking with them. It’s also important to maintain a working relationship with the buyer throughout the transaction. If an excellent working relationship is maintained, most buyers will cooperate if they default, making it possible to work out a peaceful solution quickly and inexpensively. In my experience, most buyers will be willing to work out a peaceful solution, whether by surrendering control of the business, working out another payment plan, or providing additional collateral.

If you can’t voluntarily work out a solution, then you must follow the dispute resolution options in your purchase agreement, which could be mediation, arbitration, or litigation. 

In my experience, there are two ways you can prevent a default: 

1. Perform careful due diligence on the buyer 
2. Maintain a cordial relationship with the buyer after the closing 

Don’t underestimate the value of your face-to-face assessment of the buyer’s trustworthiness. There have been many instances where sellers felt something was “off” about a buyer’s body language or negotiation methods but continued with the transaction anyway in their eagerness to close a deal – much to their regret later.

With respect to cordiality, common courtesy will go a long way toward allowing each party to communicate clearly and effectively in an environment unclouded by emotion. When both sides can clearly articulate their needs, an amicable solution can be achieved much more quickly most of the time.

Should you remain on the lease?

As the seller, make sure you remain on the lease during the entire period of the note. If the buyer defaults, you will need to take the business back and repossess the lease. 

Alternatively, you can negotiate to take back the lease if the buyer defaults without you remaining on the lease. In this scenario, you would not remain on the lease; however, you would retain the ability to take back the lease only in the event of a default by the buyer. Again, this should be addressed by an experienced broker or real estate attorney.

Can you take the business back if the buyer defaults?

You can’t take the business back without the buyer’s explicit permission or without first resorting to any dispute resolution process. Remember, when the bill of sale is signed, ownership of the business transfers to the buyer. From that point, even if the buyer is behind in their payments, the buyer has the exclusive right to the business. Without the involvement of the authorities, you can’t force the buyer to return the business no matter how legally justified you believe yourself to be.

Key Points

• For Small Businesses: If you aren’t willing to finance the sale of your business, there’s probably another seller with a reasonably priced business similar to yours who will. Sellers must consider financing the sale of the business if they’re serious about selling, especially if the business is not pre-approved for bank financing.
• For Mid-Sized Businesses: Most M&A transactions in the middle market include s0me component of seller financing, though the amounts are low, often 10% to 30% of the transaction size.