Seller financing, also known as owner financing or “holding the note,” can be an essential strategy for business owners who want to attract additional buyers or strengthen a deal under current negotiation. Seller financing can also defer capital gains on the sale of a business or be structured so that the seller receives a stream of income rather than a single lump sum.
With so many potential benefits, it is not surprising that more than half of all business sales involve some form of seller financing. M&A Firm Morgan & Westfield reports that seller financing is one of the factors that can increase the value of a business, lower taxes for the seller, and shorten the timeline of the sale. Most seller financing activity is in small business sales, but many mid-sized business deals use seller financing as part of their overall financing structure.
A 2023 Private Capital Markets Report from Pepperdine Graziado Business School surveyed 138 investment bankers. The study found that 48% of business sales transacted in 2023 involved seller financing. Seller financing accounted for 13% of the financing for businesses valued under $500K and between 8% and 10% for businesses valued between $500,000 and $5 million. For business deals between $5 million and $50 million, that percentage soared to 34% in 2023 and 2022, whereas it had hovered between 8% and 10% since 2019.
Ron Chernak, president of the FBB Group, Ltd., states in the report:
“Sellers may still need to support a transaction with some amount of alternative financing, typically seller financing or an equity rollover, in order to maximize value when dealing with a financial buyer, such as a private equity group. Sellers that are willing to be creative are more likely to sell their businesses for more money in a shorter period of time”
To be clear, not all seller-financed business sales replace the traditional bank loan. Oftentimes, the buyer will receive a smaller loan approval amount, and the seller note will make up the difference.
Seller financing is not a desperate measure. When properly leveraged, it’s an excellent resource for improving the terms and increasing the likelihood of a successful sale.
Right from the start, the willingness to offer seller financing increases the pool of potential buyers who can afford your business. If you have difficulty finding the right buyer, you can use seller financing to generate more interest. BizBuySell reports that “listings containing information about owner financing yield a noticeably higher volume of hits than those that don’t.”
There are a few reasons that seller financing could increase the final sale price of the business. The first is that you can increase buyer competition. The idea is to use multiple offers to bid up the price. Another reason is that buyers will have to compensate you for deferring payments over a more extended period of time. Morgan and Westfield report a selling price of 20% to 30% over those that don’t offer seller financing.
Standard terms in a seller-financed note include an interest rate between 7% and 10% and usually a five-to-seven-year life. The rate will always depend on the amount of risk involved. In a low-interest-rate environment, the return you can realize through seller financing might be very attractive.
Seller financing does not always make sense. You should be certain that seller financing will produce a stronger deal for you before letting the entire market know you are willing to hold the note.
With seller financing, you are not just an owner negotiating with a potential buyer. You are also a potential lender. You must negotiate with the potential buyer as such, as well as a potential borrower. Therefore, you need to evaluate the creditworthiness of the buyer and their ability to close the deal. You must decide whether owner financing is worth the risk. Explore forms of collateral when necessary.
One significant advantage you will have over a traditional lending institution is that you already know the business that will generate the cash flow to pay back the loan. So when you negotiate the note, you need to ensure the monthly payment isn’t so big that the buyer will end up delinquent or in default. On the other hand, depending on several factors, you may be able to obtain a lien on the business’s assets and take them back if there is a default.
It will also be easier to negotiate performance-based provisions in the contract. For example, you may be able to negotiate for a higher monthly payment (or balloon payment) if the company exceeds expectations.
It is always a good idea to get a sizable down payment. Frequently, seller financing becomes an alternative to a traditional bank loan because the buyer cannot secure a sufficient loan.
Even if the buyer seems very likely to make all their payments on time, you can never predict how future market or business conditions will be. It is better to live by the maxim “a bird in the hand is worth two in the bush.”
Morgan and Westfield cautions that most seller financing problems the firm sees originate from the seller accepting a down payment that is too low. To that end, experts advise most buyers to seek a down payment of 30% to 50% of the purchase price. However, if the buyer combines multiple sources of financing, the down payment percentage will vary depending on the size of the portion the seller is financing. The details will differ for every transaction, but if you hold the note, you want to protect yourself.
Seller financing, by its very nature, can foster a do-it-yourself attitude. But unless you are already an expert in mergers and acquisitions transactions, writing promissory notes, or business lending practices, seek legal and financial advice from professionals. In many cases, it is also a good idea to consult a business broker or other financial intermediary to protect yourself. Having expert advice for financing and selling your business will only benefit you in the end.
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This is an updated version of an article originally published on August 6, 2020.]
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Michele has been a director with Financial Poise since 2012. Share this page: