Seller Financing: A Strategic Approach to Business Sale Deal Structures

When selling your business, navigating the intricacies of payment structures is important. Very few transactions involve a full cash payoff at closing. One option that remains popular is seller financing. This approach involves the seller acting as the lender, providing a unique set of benefits and challenges.

Financing Options: Beyond All-Cash Transactions

All-cash transactions for business sales are the exception rather than the rule. Small business buyers typically tap into various funding sources, such as savings, stock sales, home equity, or family assistance, supplementing the remainder with a loan. For those not opting for an all-cash deal, several of the most common financing options are:

• Third-party financing. This payment approach most often involves a loan provided by a bank or credit union. For all but highly qualified loan applicants purchasing very low-risk businesses, third-party financing can be complicated and time-consuming. If part of the buyer’s payment will come from a third-party loan, early in discussions request a prequalification letter from the lender to avoid time-consuming delays later. Most third-party loans take one of three forms:
  • Traditional business loans can provide favorable terms and interest rates, but usually they also have strict qualification requirements including that the loan applicant have strong business experience and a high credit rating, and that the business being purchased has substantial tangible assets.
  • SBA 7(a) loans are offered by SBA-certified banks, microlenders, and commercial lenders and are guaranteed by the SBA in case of loan default. To qualify, an applicant must have a personal credit score that exceeds the SBA required minimum, adequate business experience, and assets to commit as collateral. Also, they must be purchasing a business with a written business plan and annual earnings that exceed a required minimum level. 
  • Home-equity loans require buyers to use the equity in their home as collateral on a loan that is usually limited to a percentage of the home’s fair market value, minus any outstanding loan obligations. A home-equity loan is secured by the home, so no payments can be missed, and the home cannot be used to secure any other loans.
• Stock exchange. This payment approach applies only when a business is being acquired by a corporation and paid for with stock, usually publicly traded stock, rather than with cash. This payment approach applies to very few business purchases, but should it become a possibility for your business, consult your attorney and accountant to weigh the obligations and risks involved.
• Seller financing, also called a seller-financed loan, involves a loan much like any other, but the seller, rather than a bank, is the lender. In most small business sales, the seller finances a portion of the purchase price by agreeing to accept a closing-day payment followed by payments from the buyer over time and with interest following the terms outlined in a promissory note.

The Pros and Cons of Seller Financing

More than nine out of ten small business sales and nearly half of mid-sized business sales involve seller financing.

The Advantages of Seller Financing

Buyers view seller financing as a favorable payment term that enhances their attraction to the business offering, reduces price negotiation, and results in higher asking-to-closing prices than sales requiring an all-cash payoff at closing.

• A seller’s willingness to accept deferred payments heightens the buyer’s confidence in the seller’s assessment of the future prospects of the business.
• Seller financing leads to a faster sale closing by eliminating the time-consuming need for bank or SBA loan applications and approval.
• By eliminating the buyer’s need for loan-origination or other fees, seller financing provides the seller with a negotiating advantage when other price concessions are requested.
• The seller receives tax advantages due to the fact that income from a seller-financed loan is spread over years rather than delivered in a single year, which can place the seller in a higher tax bracket.
• In addition to receiving a payoff over time, the seller also receives interest income over the duration of the seller-financed loan.

Seller Financing Risks and How to Minimize Them

The first risk to an owner offering seller financing is that a buyer can default on payment obligations.

The second risk is that a buyer can deplete the resources – the inventory, condition, or goodwill of the business – and then default on the loan. Even if your loan conditions allow you to foreclose and take your business back, by the time of default its condition may be far below its closing-day value.

The biggest reason for default is a buyer who turns out to be a poor business or financial manager. Take preemptive action with three essential steps:

• Verify the buyer’s qualifications from the very first inquiry up to the moment you agree to finance a loan. Request financial and business background information, then require copies of tax returns, bank statements, credit reports, and references. Then do further research on the buyer’s background and reputation, online and within your industry or business sector.
• Obtain a promissory note, also called a loan note or note payable. It includes:
  • The name of the promisor, the person who is promising to fulfill the obligations of the loan.
  • The name of the promisee (also called the obligee or payee), who is accepting the promise outlined in the note.
  • The principal amount, which is the amount being loaned under the terms of the note.
  • The interest rate, which is usually close to but often a little but not much higher than bank loan rates at the time.
  • Repayment terms, which include the interest rate and payment due dates.
  • A default clause that makes the entire outstanding balance of the loan due if a payment is missed within a certain number of days of the established due date.

CAUTION: Free legal advice sites provide samples of promissory notes, but because laws vary by state, and because this is such an important document, do not proceed without advice from your legal advisor.

• Protect yourself further by obtaining a secured promissory note. The promissory note secures the buyer’s promise to repay you following the terms of the agreement. It does not, however, secure the note or provide you with recourse if the buyer fails to make payments or declares bankruptcy, at which time all secured creditors would be paid first.
• Require collateral to secure the loan. Collateral can take several forms, including business assets, a personal guarantee, or a third-party guarantee. Each form of collateral comes with risks to avoid.
• Accepting business assets as loan security basically gives you the right to take back the business in the event of default.
  
  The risk is this: If the buyer has taken on other lenders, those lenders may have first rights to assets, and you would have a subordinated position with access only to remaining assets after others are paid. Further, the buyer may have depleted inventory or even sold valuable assets before finally defaulting on your loan.
  
  For these reasons, lenders in seller-financed loans require collateral beyond business assets alone.
• Accepting a personal guarantee as loan security basically gives you the right to pursue personal assets.
  
  The risk is this: If you sold your business as a corporation or LLC, the loan agreement would have been between your corporation (called OLDCO during the sale process) and your buyer’s newly established business entity (referred to as NEWCO). For that reason, the person to whom you sold the business no longer owns it, but rather his or her NEWCO does.
  
  Even if you sold the business to the buyer and not to a NEWCO, sometime after the sale the buyer may have transferred business assets into a corporation or limited liability corporation (LLC), of which your buyer is now a shareholder rather than the owner of the assets you sold.
  
  For these reasons, lenders in seller-financed loans need to obtain the buyer’s personal guarantee (and also the buyer’s spouse’s personal guarantee if your attorney so advises). This allows you to pursue personal and jointly owned assets, if necessary.

CAUTION: Securing a seller-financed loan requires legal assistance. In some states, it takes the form of a cognovit note that paves the way to rapid judgement and loan collection.

• Accepting a third-party guarantee as loan security provides assurance that a high net worth relative or associate will guarantee the debt. Before accepting this option, do your homework. Require the guarantor’s financial statement and credit report and perform a thorough due diligence before closing the deal.

Seller financing is a powerful asset in the toolbox of business sale strategies. By understanding its dynamics, advantages, and risks, sellers can leverage this approach to attract buyers, expedite closings, and optimize financial outcomes. As you embark on the journey of selling your business, consider the strategic implications of seller financing to unlock a more lucrative transaction.