Seller Financing: What It Is and How It Works
Laura Roden’s career in financial services has covered the spectrum from investment management, brokerage, banking and corporate finance to teaching finance and entrepreneurship at the college and graduate school levels. She earned both her undergraduate and MBA degrees from Harvard University, and holds Series 7, 63 and 65 FINRA licenses. She has been a featured speaker on finance topics at the Milken Global Conference, the New York Society of Security Analysts, the Inc 500 conference and the Angel Capital Association as well as many other venues.
Janet Schaaf is a freelance writer, editor and proofreader who considers reader advocacy to be her calling. After taking a few roads less traveled, Janet completed a bachelor’s degree in English Literature from the University of Missouri-Kansas City, with English Department Honors. She has been correcting grammar and checking facts since she could string a sentence together. For the past three years, Janet has focused on making personal finance topics understandable and relatable. Loan terms and credit card agreements can look overwhelming, but understanding what you’re agreeing to is paramount in grasping the impact debt can have on your life.
Seller financing makes buying or selling a business easier: It’s a loan from the seller to the buyer to help pay for the purchase. Seller financing, also called owner financing or seller carryback, must be paid back over time with interest, but it could mean the difference between getting a deal done or walking away from the table. We’ll guide you through the pros and cons for both sellers and buyers to help you decide if it could work for you.
How does seller financing work for a business?
After making a cash down payment of between 30% to 60% of the purchase price, buyers may choose to finance the rest with seller financing, sometimes in combination with loans from traditional lenders or other sources. Because the seller is taking on repayment risk, they usually require a credit report, business references or other evidence of buyer creditworthiness.
Seller financing of a business purchase requires at least two important contracts:
- A purchase agreement defining what is being sold to whom and for what price
- A promissory note that defines the amount of the loan and repayment terms
The promissory note often includes a buyer personal guarantee provision, which makes the buyer personally responsible for the company’s debt. If physical assets are included in the purchase, a collateral agreement (often called a UCC filing) is also needed. Both buyer and seller should review these documents with a qualified advisor, like an attorney or business broker, before signing them.
When should you consider seller financing?
Buyers
You can’t access other forms of financing quickly enough: If you don’t have enough cash to buy a business outright, it can take months to get financing. Lenders like banks have strict documentation and due diligence criteria, while equity investors can be time consuming to find and negotiate with. The seller, on the other hand, already knows the business well and is motivated to close a sale quickly.
You want to reserve cash for other business needs investment: When you buy a business, you’re also going to need cash for expenses like legal bills, facilities improvements or inventory. By getting a loan from the seller, you can reserve your own 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 like the business is in good shape: 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. Depending on the terms of the promissory note, however, 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. Do not accept a loan unless you feel confident that the business you’re buying will provide enough revenue for you to repay the debt.
Sellers
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 buyers also means the possibility of a bidding war that will increase the selling price of your business. Also, by allowing a buyer to pay you over time, they’re likely able to afford a higher purchase price.
You want to reduce your tax liability: Generally speaking, if you’re paid by the buyer in installments, you will only owe taxes when you receive the payments. This stretches your tax payments out over a few years. But be aware that future changes in tax rates and your own 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 pertaining to your specific circumstances.
What are the risks of seller financing?
There are two kinds of risks for both 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 that the seller is either disruptively meddlesome or not as helpful in the transition as promised.
- The seller, on the other hand, may find themselves burdened with continuing responsibilities to make sure the business succeeds and they can be repaid.
Pros and cons of seller financing
| Pros for sellers | Cons for sellers |
|---|---|
May attract more buyers May achieve higher selling price May lead to faster closing | Ties up capital Risk of payment default May need continuing involvement |
| Pros for buyers | Cons for buyers |
|---|---|
Indicates seller confidence in business Faster than traditional loans Conserves cash for other upfront needs | Possibly higher purchase price Possibly higher interest rate Management meddling |
How to find additional funding to complete a seller financing deal
Seller financing doesn’t always cover the entire purchase price of a business, so a buyer may need to find additional sources of financing. Some options include:
Rollovers as Business Startups (ROBS)
A ROBS is a way for a business owner to tap into their retirement funds to finance acquisition of or startup costs for a business. The arrangement involves rolling one’s retirement funds to a ROBS plan — a tax-free transaction — and then using the money to start a business or buy a business by having the retirement plan acquire stock in the new company.
SBA loans
The Small Business Administration (SBA) works with a network of financial institutions to provide loans to small businesses that can’t get needed funding from traditional financing sources. A credit score of 680 or more is ideal for meeting SBA loan requirements but some types of SBA loans have lower credit score minimums.
Bank loans
Traditional business loans from banks can be used to help finance the purchase of a business if the buyer is creditworthy and the business has a strong operating track record. Banks commonly require borrower credit scores of at least 680, and two or more years of business financial statements documented with bank statements and tax returns.
Home equity lines of credit (HELOCs)
With home equity lines of credit, you borrow against the equity in your home and use the money for either personal or business needs. There is a draw period followed by a repayment period. A HELOC may be an option for those whose home value is significantly higher than their existing mortgage, but keep in mind that if you default on a HELOC, you could lose your home.
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 occurs 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 is widely used because it 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 own situation to see if these tradeoffs are worth it for you.