Seller Financing: What It Is and How It Works

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 30% to 60% of the purchase price, buyers may 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:

1. A purchase agreement defining what you’re selling to whom and for what price
2. A promissory note establishing 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. You also need a collateral agreement (often called a UCC filing) if the sale includes physical assets. Buyers and sellers should review these documents with a qualified advisor, like an attorney or business broker, before signing them.

Pros and cons of seller financing

Seller financing vs. business acquisition loans

Business acquisition loans are another way to finance the purchase of a business.

While seller financing involves the seller offering a loan to the buyer, financial institutions like banks, credit unions and other lenders provide business acquisition loans. These loans often allow longer repayment terms and potentially larger loan amounts — potentially allowing buyers to finance more of the purchase price.

In seller financing, the buyer and the seller may have a direct relationship. For example, the existing business owner might sell the company to an employee or family member. This usually isn’t the case with business acquisition loans, so they often have more stringent qualification criteria and stricter repayment terms.

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 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 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.

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 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. 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. 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 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.