In the right circumstances, seller financing a business can be the key to negotiating a better deal or closing more quickly. Seller beware, however, because cash is king, and you will have to sue a buyer who defaults on an obligation to pay a seller note.
Seller financing, also known as owner financing or “holding the note,” can be an important 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. In some online marketplaces, such as BizBuySell, more than half of brokers report seller financing in more than 60% of their closed deals. Keep in mind that BizBuySell focuses on smaller businesses; the larger the business, the less likely it will be that seller financing comes into play at all.
Potential buyers in smaller deals often request seller financing. A 2019 report from Pepperdine Graziado Business School surveyed 292 business brokers and M&A advisors for Main Street (<$500K to $2MM) and middle-market businesses ($2MM-$50MM). The survey found that for businesses valued at less than $500K, 10% of the total sales price was financed by the owner, and for businesses valued from $1MM to $2MM, 17% of the total sales price was financed on average. These numbers are down from 2017, when buyers had smaller cash reserves.
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 a great 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 are having a difficult time 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: buyers will have to compensate you for deferring payments over a longer period of time. The Business Brokerage Press finds owner financing increases the average sale value by 10–15%.
Common terms in a seller-financed note include an interest rate between 7% and 10% and normally a five-to-seven-year life. 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. In fact, you should be pretty certain 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 his or her ability to close the deal. You must decide whether owner financing is worth the risk. Explore forms of collateral when necessary.
One major advantage you are going to have over a traditional lending institution is that you already know the business that’s going to generate the cash flow to pay back the loan. So when you negotiate the note, you need to make sure the monthly payment isn’t so big that the buyer will end up delinquent or in default. On the other hand, depending on a number of factors, you may be able to obtain a lien on the assets of the business and take them back if there is a default.
It will also be easier for you 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 for a traditional bank loan because the buyer could not secure a sufficient loan.
Even if the buyer seems very likely to make all of her 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.”
Seller financing, by its very nature, can foster a do-it-yourself attitude. Unless you are already an expert in mergers and acquisitions transactions, or maybe business lending practices, you will be better off if you seek legal and financial advice from professionals. In many cases, it is a good idea to also consult a business broker or other financial intermediary.
©All Rights Reserved. August, 2020. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Michele has been a director with Financial Poise since 2012.
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