Business Seller Financing: What It Is and How It Works
Seller financing — also called owner financing — is an arrangement where the seller extends financing to a buyer, allowing them to purchase a business without involving a commercial lender.
Often, this type of financing agreement is used when sellers are unable to find buyers who can qualify for traditional business financing. While it may not sound ideal, it can mean the difference between securing a buyer and not selling at all.
- Seller financing is an arrangement that allows the seller of a business to extend private financing to the buyer without involving a third-party lender.
- There’s some risk involved, mainly due to a lack of professional oversight and extra administrative burden, but it might be worth it for sellers if more qualified buyers are scarce.
- Buyers who aren’t able to qualify for traditional financing or want access to a quicker option may benefit from seller financing.
How does seller financing work for a business?
Seller financing arrangements are unique in that the buyer and seller can structure them however they see fit. Here’s an overview of how these business deals typically work:
Step 1: Contract negotiations
Once the seller has found an interested buyer, the first step is for the two parties to come together to negotiate the terms of the contract. The goal here is to agree on terms that are reasonable for both parties.
- Purchase price: The amount of money for which the business is being sold. Because of their flexibility, seller financing arrangements can usually garner a higher purchase price than traditional lender agreements.
- Down payment: An upfront payment amount, usually expressed as a percentage of the sale price. Seller financing arrangements typically feature higher down payments than traditional business loans, ranging from 10% to 50% of the purchase price.
- Loan amount: The total amount being financed, typically the purchase price minus the down payment.
- Repayment terms: The amount of time the buyer has to pay back the loan, as well as the amount that the seller is responsible for paying in each installment and the frequency with which the installment payments should occur.
- Interest rate: What the seller charges the buyer in exchange for extending them financing, usually expressed as a percentage of the loan amount. Seller financing agreements can typically charge higher interest rates than most business acquisition loans.
- Fees: Any additional charges associated with the loan, such as an origination fee to cover the administrative cost of putting the loan documents together or a late payment fee.
- Collateral: Any asset used to secure the loan in the event that the buyer stops making payments. In owner financing arrangements, it’s common to see UCC filings or a lien against the business’s assets.
- Special clauses: These agreements typically include a personal guarantee provision, which puts the buyer on the hook for repayment if the business defaults on the loan. Balloon payments are also common, which require that the remainder of the loan balance be paid in one lump sum after a certain period of making regular installment payments.
Step 2: Due diligence
Next, both parties need to do their due diligence to make sure they’re getting a fair deal.
Sellers: Sellers need to ensure that the buyer is financially capable of making the payments laid out in the contract negotiations. You may want to ask for the buyer’s credit score and a copy of their credit report, plus a few business references as evidence of their creditworthiness.
Buyers: Buyers should also do their own research to ensure that the business is worth what they are intending to pay for it. You’ll want to ask the seller for copies of the business’s financial documents, such as a balance sheet and profit and loss statement, to confirm that the business is financially sound.
Step 3: Drawing up the contracts
Seller financing of a business purchase requires at least two important contracts:
- A purchase agreement defining the parties to the loan and the details of repayment
- A promissory note establishing the loan terms and the consequences if the buyer defaults on their payments
Once the terms are in writing, the buyer and seller should review these documents with a qualified advisor, like an attorney or business broker, before signing them.
Step 4: Beginning repayment
After the contracts have been signed, the buyer should begin making payments as outlined in the business loan agreement.
Pros and cons of offering financing as a seller
Pros for sellers
- May attract more buyers
- May achieve higher selling price
- May lead to faster closing
Cons for sellers
- Ties up capital
- Risk of payment default
- May need continuing involvement
Pros and cons of using seller financing to purchase a business
Pros for buyers
- Indicates seller confidence in business
- Typically faster than traditional loans
- Conserves cash for other upfront needs
Cons for buyers
- Possibly higher purchase price
- Possibly higher interest rate
- Sellers may want to be involved in management
What are the risks of seller financing?
There are two kinds of risks for buyers and sellers in a seller financing agreement: financial and management.
Financial risk:
- The seller is taking the risk that they may not get paid on time or in full.
- The buyer is taking the risk that if they default, the seller can repossess the business assets and potentially even the buyer’s personal assets.
Management risk:
- The buyer may find the seller either disruptively meddlesome or not as helpful in the transition as promised.
- On the other hand, the seller may find themselves burdened with continuing responsibilities to ensure the business succeeds so the buyer can repay them.
When should buyers consider seller financing?
Consider purchasing a business with owner financing instead of a traditional business loan if:
You can’t access other forms of financing
Many business lenders have minimum time in business requirements, meaning you can’t qualify if you don’t already own a business. This is fine if the business you want to buy is your second or third one, but it can make it difficult for first-time business owners to get financing.
If seller financing is the only type of financing you can get, then it might be worth a high interest rate — as long as the business is still profitable after you make payments to the seller.
You want to buy a business quickly
If you don’t have enough cash to buy a business outright, it can take months to get funding. Lenders like banks have strict documentation and due diligence criteria, while it can be time-consuming to find and negotiate with equity investors.
On the other hand, the seller already knows the business well and is motivated to close a sale quickly. However, it’s important to not move so quickly that you miss important steps, like doing your due diligence to make sure the business is viable.
You want to reserve cash for other business needs
When you buy a business, you also need money for expenses like legal bills, facility improvements or inventory. By getting a loan from the seller, you can reserve your cash for these out-of-pocket costs. Having enough money in reserve to cover expected and unexpected needs can protect the long-term value of your investment.
You feel confident the business is profitable
When a seller offers financing, it’s a sign they have faith the business will do well and that you will be able to repay them. However, depending on the terms of the promissory note, the seller may be able to repossess the business assets and even put a claim on your personal property if you default on loan payments.
It’s typically a bad idea to accept a loan unless you feel confident that the business you’re buying will provide enough revenue for you to repay the debt.
When should sellers consider offering financing?
If you’re in a financial position where you can offer financing to potential buyers without too much strain on your own finances, it may be a good idea if:
You want to reach more potential buyers
Offering seller financing should bring you a bigger pool of potential buyers, including those with limited cash on hand or less access to traditional financing. The more qualified buyers who are interested, the better the odds of finding one that’s a mutually good fit.
You want a higher sales price
More potential buyers also means the possibility of a bidding war that could increase the selling price of your business. Also, by allowing a buyer to pay you over time, they may be able to afford a higher purchase price.
You want to reduce your tax liability
Generally speaking, if the buyer pays in installments, the seller only owes taxes when they receive the payments. This stretches your tax payments out over a few years.
But be aware that future changes in tax rates and your tax bracket can positively or negatively affect the actual amount of taxes you’ll eventually have to pay. Consult with a tax professional for advice on your specific circumstances.
Alternative ways to buy a business
There are many ways to finance the purchase of a business. Here are some alternatives to seller financing to consider.
- Buy it outright. Buy the business for its full purchase price with your own funds. This method gives you complete ownership and control without taking on debt or sharing profits. However, it requires significant upfront capital.
- Partner with the existing owner. Partnering with the current owner allows you to leverage their experience and established business relationships while reducing your initial investment.
- Take out a loan. Secure a business loan from a bank or lender. This approach provides the necessary capital while allowing you to spread the cost over time, although it requires good credit and a solid business plan.
- Crowdfund. Crowdfunding involves raising money from a large number of people, typically through an online platform like GoFundMe. This method may work best for businesses that benefit the community because you can build a supportive customer base from the start.
- Use a combination of the above. Mix different financing methods to suit your needs and financial circumstances. For example, you could buy a client list outright while financing new equipment.
Frequently asked questions
You can find seller financing contract templates for purchase agreements and promissory notes on a variety of websites. Some provide free templates, while others may charge for access. Try these to start:
A seller financing promissory note describes exactly how much the buyer will pay to the seller, including the total number of payments and when they will be due, as well as what will happen if the buyer defaults on payment. It is a legally binding contract. There may be differences in legal format between states, so check your local requirements.
Seller financing for business can provide real value to both buyers and sellers. Sellers find more potential buyers, and buyers get the funds they need to afford the purchase. However, buyers often pay higher prices, and sellers take on default risk. Analyze your situation to see if these trade-offs are worth it.
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