Seller financing is when the current owner of a business provides a loan to the new buyer to cover a portion of the purchase price. After reading this article, you should understand:
- Why seller financing is an attractive part of a business acquisition
- Things to keep in mind when using seller financing and bank financing
- The typical amount and terms of selling financing
Did you know? If you have more than $50k in a retirement account, you can use those funds to finance your business without early withdrawal penalties or taxes. It’s called a rollover for business startups (ROBS). Speak with a ROBS professional at Guidant.
What is Seller Financing?
Seller financing is exactly what it sounds like. The seller gives a loan to the purchaser of the business that covers some of the purchase price. The remainder is covered by the buyer’s down payment and sometimes by other sources of financing.
Sellers who offer financing act a lot like a bank. They will generally check the credit report of the buyer, personal financial statement, resume, and other pertinent information before making the loan. They may also request collateral and a personal guarantee to secure the loan.
To increase the chances of getting seller financing, buyers should make sure they have a strong credit score. A good credit score is 680 or above. Above 725 is considered great. You can check your credit score for free here.
Note: If your credit score needs improvement, get a free consultation from My Credit Group.
How Popular is Seller Financing?
The largest online marketplace for buying and selling businesses, BizBuySell, regularly surveys business brokers about topics like prices and financing. In a survey last year, brokers reported that 60 to 90 percent of businesses for sale included seller financing.
Why is Seller Financing Beneficial?
Most sellers are initially reluctant to provide seller financing because of the risk that the buyer won’t pay back the loan, but it can benefit both the buyer and the seller.
Seller financing helps the seller attract buyers and get a higher price for the business. Many buyers don’t have enough cash to cover the full purchase price of a business plus initial working capital needs, and without seller financing, you restrict the pool of buyers to those who can pay for the business out-of-pocket. Even if such buyers exist, it will take a longer time to find them and sell the business.
With seller financing, you can attract more buyers and price the business higher because you are providing financing, which allows the buyer to pay for the business over a period of months or years. Many serious buyers will not even commit to buying a business that doesn’t offer seller financing because if the seller has no skin in the game, the business opportunity does not look very attractive.
In addition, if the buyer needs a bank loan or SBA loan to cover the purchase price, the lender will want to see seller financing and will typically prefer deals that include seller financing. Why? Because seller financing is evidence that the seller believes in the future of the business and the owner. It also reduces the lender’s exposure to the deal.
What are the Typical Terms of Seller Financing?
- Covers 30% – 60% of the purchase price
- 5 – 7 years
- 6% – 10% Interest Rates
How Much of the Purchase Price Will Seller Financing Cover?
Sellers will typically finance about 30-60% of the purchase price of the business, but every transaction is unique, and some owners may offer more or less financing. For example, if the business is of a type that lenders traditionally won’t provide money to (e.g. insurance businesses), it may be covered by more seller financing. Likewise, if a business doesn’t have collateral that can be used for a traditional loan, the buyer may be more dependent on seller financing.
Most of the time, however, seller financing usually makes up a relatively small portion of the purchase price and is used in conjunction with other types of financing. To cover the non-seller financed portion of the purchase, many buyers use bank or SBA financing or a Rollover For Business Startups (ROBS).
ROBS allows you to use retirement money to buy a business without incurring taxes or penalties. A ROBS gives you flexibility when starting a business because it’s your own retirement money, so you can start the business with less debt. For example, if a business is sold for $500,000, $200,000 may be seller financed. 60% of the purchase price then remains. The buyer may bring 20% down in cash (either out of pocket or from a ROBS) and get the remaining 40% financed with an SBA loan or bank loan.
Interest Rates and Length of Loan
The interest rate of a seller note is typically at or below bank rates, and the length of the loan is also usually similar to that of a bank. The terms of the loan have a lot to do with the specifics of the deal and the buyer’s ability to afford the loan payments. Would the terms of the loan payment allow the new business owner to pay themselves a livable wage and make the payments on the loan based on the business’ cash flow? While the seller wants to make the most possible money from the sale of the business and related loan, they also do not want the buyer to default because of unrealistic debt payments.
Seller Financing and Bank Loans
Since seller financing usually doesn’t cover the entire purchase price, most buyers need some additional financing to buy a business. This usually comes in the form of a bank loan or SBA loan.
In order to get a bank or SBA loan, you generally need to have excellent credit, collateral, and a down payment of 10-30% of the loan amount. For the down payment, you will need to bring cash to the table. If the rest of your application is very strong, the lender may consider seller financing as part of the down payment.
Whenever seller financing is used in conjunction with an SBA loan or bank loan, there are usually two rules the lender will require you to follow:
1. The seller must be in full or partial standby for at least 2 years.
Standby affects the seller’s ability to receive payment on the loan from the buyer. Full standby means that the seller won’t receive any payment on the loan for 2 years. Partial standby means that the seller will receive interest-only payments for 2 years.
The Small Business Administration (SBA) requires sellers to remain in partial or full standby for 2 years (full standby is preferred). Banks will also usually impose this requirement for non-SBA conventional loans.
2. The seller must subordinate to the bank or SBA loan.
In addition to accepting standby status, the seller must also subordinate to an SBA or bank loan. This means that if the buyer defaults and the business closes down, the bank gets first dibs on the proceeds from the sale of any collateral.
For obvious reasons, a seller may be hesitant to accept these conditions, but this is how the bank and SBA protect themselves when multiple forms of financing are needed for a business acquisition.
What Protections Do Sellers Typically Demand in Exchange for Financing?
Sellers often place some or all of the following as conditions on the availability of seller financing:
- Control of the business if there is non-payment.
- Real estate as collateral.
- A personal guarantee.
A seller’s biggest fear when providing seller financing is the buyer defaulting on the loan. To avoid this from happening, sellers generally want terms that give them the right to take back control of the business within 30 or 60 days of the buyer missing payment. However, the biggest assets of many small businesses are intangibles, often referred to as goodwill (like customer and supplier relationships). By the time the old business owner takes back control, customers can be permanently lost and supplier relationships broken, making the business far less valuable.
For businesses that operate with a substantial amount of inventory, there are sometimes clauses which require the new business owner to keep inventories at certain levels. In the case where the seller resumes control, they will at least not need to have to make a large expenditure on inventory.
Ideally, the seller would like the buyer to put up collateral for a loan, real estate in particular. There are several problems with a seller requesting collateral. First, there is often a mortgage on a house. The bank holding the mortgage has the first claim to the house. Second, there may not be much owner equity in the house after the mortgage is deducted. While the house could be sold even if the business collapses, that doesn’t mean it will bring in much money. Finally, if part of the business purchase is financed with a bank loan, the seller’s rights to proceeds from collateral are secondary to the bank’s.
What Legal and Professional Help Should One Get With Seller Financing?
In many business sales, a business broker is involved. However, buyers should remember that the business broker works on behalf of the seller, and the seller generally pays the broker fees. In addition to the broker, buyers and sellers often involve their lawyers, accountants, and appraisers to value the transaction and go through the financials and paperwork. For more on how to value a business, read our in-depth article.
Have a general legal question about the seller agreements? Get Free Answers From Lawyers. As long as your question is relatively general and not related to a specific situation, you can get free answers from lawyers on Avvo. By giving a “free sample” they hope to snag you as as client.
Paperwork and Contracts Involved with Seller Financing
Typically, there are several legal agreements that need to be drafted and signed as part of a business acquisition. Here are the main documents, as well links to some free templates (you should have an attorney review and customize all paperwork as necessary for your deal):
- Letter of Interest (a preliminary framework for negotiating the terms of sale)
- Deal Contract (the final terms of the sale of the business)
- Promissory Notes (the loan document for seller financing and other loans)
- Security Agreement (describes what and how the lender can access collateral).
- The new lease for the commercial property (if applicable)
- Transfer documents for any vehicles that may be part of the purchase
- Bill of sale (transfers ownership of tangible business assets)
- Non-compete agreement from the seller (if applicable)
- Bulk sale documents (govern the sale of inventory)
- IRS Form 8594 (shows how assets are allocated during the purchase)
- Consultation/employment agreement (these are necessary if the owner will be staying on as a consultant or employee to aid with the transition of the business)
A Final Word on Seller Financing
In preparation for this article, we interviewed Josh Patrick, a well-known small business columnist for the New York Times and founder of a wealth advisory service for business owners. Several years ago, Patrick owned a vending machine business. The business grew to around 90 employees when Patrick decided to sell it. The purchase price, which was in the millions of dollars, was paid 95% in cash, and the remaining 5% was seller financed. Shortly after the sale of the business, the new owner lost a major account and didn’t want to pay the 5%. In the end, Patrick was able to prove that the account was lost because the new owners left food rotting in a vending machine. However, it took a significant amount of time and legal costs for him to recover the money.
Although seller financing certainly has some inherent risks, as this example shows, it’s often necessary to entice buyers and close a deal. The best advice for a seller would be to place new ownership of the business in trustworthy hands and assist the new owner when possible. The best advice for a buyer would be to bring as much cash and personal resources to the table as possible and only use as much seller and additional financing as needed. This will help ensure that the business succeeds and the buyer is able to afford loan payments.
Both buyers and sellers stand to gain from seller financing. If you are a buyer, seller financing can give you the capital you need to actually make the purchase happen and make other lenders more likely to provide you with financing. If you are a seller, offering seller financing will bring you more prospects and perhaps let you charge a slightly higher price for the business.
Ready to buy or sell a small business? Get guidance you can rely on with Murphy Business & Financial Corporation, a nationwide business broker. They have a closing rate that’s roughly twice the national average. Set up a free consultation with a highly trained Murphy business broker today.