Buying a Business With Seller Financing

Most entrepreneurs don’t start out with the cash they need to buy a business. If tapping into your friends and family doesn’t yield enough to fund your business acquisition, you can use your personal funds, get a traditional business loan, or buy a business with seller financing.

What Is Seller Financing?

Seller financing is a common practice for funding the acquisition of a small business. The seller of the business acts as the bank and lends the buyer a negotiated sum toward the asking price of the business.

Also called owner financing, seller carryback, or a seller’s note, the seller in these arrangements loans the buyer a portion of the business’s purchase price in exchange for a promissory note to repay the loan on a predetermined repayment schedule. The buyer makes payments in monthly installments to the seller until the loan is paid off.

Just as with traditional financing, the monthly payments include interest and principal, with interest accounting for a larger portion of the monthly payment earlier in the repayment schedule and principal accounting for a larger portion as the loan term nears its end. In some cases, a balloon payment (a lump sum of the balance owed) might be required at the end of the term.

Seller financing for a business acquisition works the same way as a bank loan. The difference is that financing terms for seller financing are usually more flexible because they’re negotiated between buyer and seller.

How Seller Financing Works

Sellers typically express their willingness to offer an owner financing arrangement when marketing the business. But as a buyer, you can also ask a seller to consider carrying some of the cost of the purchase. Often, sellers might entertain financing a business sale to attract the right buyer because of the tax advantages this type of sale offers.

Keep in mind, however, that just as a bank would want to know that the business buyer is capable of running the business and has good credit, so too business owners willing to finance a sale will insist on qualifying the buyer for the loan.

Buyers are usually required to submit financial statements, resumes, employment history, and a credit report. A seller might also ask for a business plan.

In many cases, sellers will also require collateral, such as a home or personal assets, to ensure that the loan will be repaid if the buyer defaults. A seller might also require that the buyer meet specific financial benchmarks post-closing, such as maintaining a minimum inventory level or working capital.

If a seller is willing to consider carrying a note on the business, both parties must negotiate the loan amount and the terms and sign a promissory note detailing those terms.

How Much of the Price of the Business Do Sellers Typically Finance?

Sellers rarely are willing to finance the full purchase price of a business. After all, a buyer with no vested interest has very little to lose if the business fails. Beyond this general rule, however, the amount that a buyer can expect a seller to finance depends on the sale price of the business, the seller’s situation and goals, the buyer’s creditworthiness, and the amount buyer and seller negotiate.

As a buyer, you should expect a seller to lend anywhere from five percent to as much as 60% of the purchase price of the business. If the seller wants to disengage from the business as quickly as possible, they’ll likely want to keep the loan amount low. But in other cases, sellers might prefer an arrangement where they receive a steady income from the financing and loan a larger percentage of the purchase price.

Seller Financing Terms

Interest Rates

Interest rates for seller-financed acquisitions depend on the risk factors involved more than the cost of money at any given time. Generally, sellers offer rates that are the same or lower than prime rates. But it’s also not unusual for sellers to bump up the asking price of the business to compensate for the risk involved in financing the purchase.

A seller will usually look at these risk factors to set an interest rate:

• Total price of the business
• Buyer’s credit score
• Buyer’s experience running a business
• Amount of the down payment.

Just as banks impose higher interest rates for those whose credit scores are lower, so too will most sellers adjust interest rates upward or downward depending on the buyer’s credit score.

Down Payment Percentages

Like the other loan terms, the amount of the down payment required depends on the total purchase price of the business, the seller’s situation, and the amount that the buyer and seller negotiate.

In general, buyers should expect to cover a down payment ranging from 10% to 50% of the loan amount.

Keep in mind that the cash flow from the business must be sufficient to cover the monthly loan payments. Asking for a small deposit requirement means you’ll pay higher monthly installments, and sellers will evaluate your ability to repay the loan based on the business’s anticipated cash flow.

Average Loan Term Length

Usually, seller financed business loans are granted for a term of five to seven years, however the term of the loan, like other factors, is also negotiable.

What If You Need Additional Sources of Financing?

Because seller-financed business loans don’t usually cover the full amount of the sale price, you might need to seek an additional type of financing to buy the business you want.

Some of the financing options available for closing the gap between the amount the seller is willing to finance and the selling price of the business include:

401k Business Financing

The IRS permits business owners to roll over tax-free funds from their retirement accounts to fund startups or business acquisitions. The program, known as Rollovers as Business Startups (ROBS), requires the business you are financing to operate as a C Corporation. Other requirements apply.

SBA Loans

SBA loans are loans offered by traditional lenders and guaranteed by the federal government. The SBA offers several different types of loans to small business owners.

Bank Loans

In some cases, a buyer who might not qualify for a traditional bank loan to purchase a business can use a traditional lender for a loan to cover the gap between seller financing and the cost of the business. Banks typically consider the seller-financed portion of the business as equity, so they’re more willing to qualify a buyer for this type of loan than for one to finance the entire business acquisition.

Home Equity Line of Credit (HELOC)

If you own your home, using a home equity line of credit is another option for financing the purchase of a business. With a HELOC, you borrow money against the equity in your home with a set period for paying back the loan.

Pros and Cons of Using Seller Financing

Seller financing gives many who don’t otherwise have the financial resources to buy a business the opportunity to become business owners. But a seller financing deal has additional advantages for both buyers and sellers.

Pros of Using Seller Financing for Buyers

Compared with a bank loan, a seller financing deal is often faster and has better terms.

• Unlike bank financing, buyers don’t have to go through multiple layers of approval, a time-consuming process that can often slow down and even derail a sale.
• Seller financing often has lower interest rates, and there are no upfront closing costs, as is customary with bank loans.
• A seller willing to carry a note on a business is likely confident that the business will generate a healthy income, so buyers, in turn, can be more confident that the business they’re buying is poised for success.

Cons of Using Seller Financing for Buyers

While seller financing can be your ticket to business ownership, it can also impose conditions that some entrepreneurs might find unreasonable or just plain meddlesome.

• Sellers can interfere with daily operations to ensure that their loan will be repaid. This is especially true when sellers insist new owners adhere to reporting and other financial requirements.
• In most cases, using seller financing will result in a higher sale price for the business.

Pros of Seller Financing for Sellers

Many deals fall through because buyers don’t have the financial means or access to capital they need to close the deal. So sellers can help ensure a successful sale by offering to finance the deal.

Seller financing can offer additional benefits to sellers, such as:

• Increasing the pool of potential buyers can help sell the business faster and increase the purchase price.
• It reduces tax liability because payments are spread out over a longer period of time, so taxable gains are also spread out over that period.

Cons of Seller Financing for Sellers

Financing a sale entails additional risks sellers don’t face with an all-cash deal.

• If the buyer mismanages the business and defaults on the loan, a seller might not have much to recover and be left with a loss.
• Tying up funds through seller financing can leave sellers without the resources to pursue other ventures.

Best Practices for Using Seller Financing

Buyers should do their due diligence when considering a seller-financed deal. In addition to scrutinizing a company’s balance sheet, buyers should conduct a credit check on the business owner and the business to ensure they are in good standing.

Sellers will want to protect their investment by:

• Making sure the promissory note addresses non-payment and late payments.
• Filing a Uniform Commercial Code (UCC) lien on the business to prevent the buyer from selling it before the loan is paid.

Buyers and sellers can benefit by enlisting the aid of professionals, including a transactional attorney and a business broker, for any business sale, but especially one that’s seller financed.

These professionals will look out for your interests during negotiations and ensure that all documentation holds up to scrutiny should any disputes arise down the road. Visit the BizQuest Broker Directory to find a business broker to help you negotiate the purchase of a business using seller financing.