In this article we will discuss seller financing, which is when the seller of a business provides a loan to the new buyer to cover a portion of the purchase price.  After reading this article you should understand why seller financing is so frequent, the typical terms of seller financing, and what protections most seller financed deals include.

How Frequent Is Seller Financing?

The largest online marketplace for selling businesses, BizBuySell. regularly surveys business brokers about topics like prices and financing. In the most recent survey they reported:

When asked about their sales, 26 percent of brokers said nearly all (90 to 100 percent) of their closed sales include seller financing while another 32 percent noted that most (60 to 89 percent) included it.

BizBuySell’s May 2014 Broker Survey

Bob House, the General Manager of BizBuySell indicated that about ⅓ of the listings in the BizBuySell marketplace publicly advertise seller / owner financing. However, he believes that the majority of deals which get done, particularly those with smaller dollar amounts have owner financing. These sentiments were shared by Ed Pendarvis of Business Broker University who indicated almost all the deals with a price tag of under $500,000 involved seller financing.

Why is seller financing so popular?

Because banks do not like to finance the purchase of small businesses.

Banks have two basic requirements when they make a loan:

• Confidence in the borrower’s ability to repay the loan.
• Collateral to sell, if the borrower does not or cannot pay back the loan.

Unfortunately, there are  problems meeting both of these conditions when it comes to financing the sale of a small business. By small Business, I mean those which are being sold for less than $2 million.

What prevents bank financing?

• The new owner’s lack of experience in running the business.
• IRS tax returns show poor financial numbers.
• The business does not count as quality collateral.

Let’s say that a business being sold is financially healthy and generating a predictable cash-flow. On paper, it looks like the business should be able to support monthly loan payments. (Generally, this means that the business is earning at least $1.25 in cash for every $1 of loan payment.)  However, the past performance of the business is based on having an experienced owner in charge. The new owner may not have experience running a business, or expertise in the field which the business operates. In short, the management change makes banks reluctant to count on the business’s past performance.

The financial numbers often scare banks away without even taking into account the management change.  Banks rely heavily on IRS tax returns in assessing the financial health of a business. However, small businesses often try to minimize the amount of profits that they report to IRS.  It’s widely known that many small businesses which take cash payments don’t report all of their sales.  An existing business owner may claim that a business is generating lots of profits when you include unreported income, but these claims mean nothing to a bank which is looking at the IRS returns.

Lastly, there is the issue of collateral.  Borrowing to buy a house, where the house serves as the primary collateral, is very different than buying a business.  If a person is not able to make payments on their house, it generally doesn’t impact the resale value of the house. The bank should be able to get back all the money it loaned by selling the collateral.  With a small business, the business is generally not doing well if the business owner cannot make payments. As a result, the bank will probably have to accept a very low resale value in comparison the original sale price. The business itself does not make good collateral.

The Exception To The Rule Franchises

New business owners are often able to get financing for the purchase of a franchise.  Franchises are seen by banks as having less risk, particularly management risk. Those with no previous experience running a business, typically apply for a bank loan with an SBA guarantee.

If you are interested in buying a franchise see our full guide on franchise financing .

What percentage of the sale amount is typically seller financed?

• 60 70% of the sales amount is typically owner financed

For a business which is sold for $500,000, a typical deal might include $300,000 in owner financing and a $200,000 down payment from the buyer. The business brokers I spoke with highlighted the importance of the buyer having “skin in the game”.  However, there are no hard and fast rules for seller financing. The less attractive the business, the more likely the seller will have to do a greater share of financing. Deals in which the seller lends 80% of the purchase price do occur.

What are the typical terms for owner financing?

• 5 7 years
• 6 % 10% Interest Rates

The four people that I interviewed for this article all gave slightly different answers to this question. However, there was one common theme. The terms of the loan had as much to do with the buyer’s ability to make payments, as they did with market rates. Would the terms of the loan payment allow the new business owner to pay themselves a livable wage and make the payments on the loan based on the businesses cash flow? While the seller wants to make the most possible money from the sale of the business and related loan, they also did not want the buyer to default because of unrealistic debt payments.

What is a livable wage for the business owner? The number that came up was $50,000 per year.

What protections do seller’s try to demand in exchange for financing?

• Control of the business, if there is non-payment.
• Real Estate as collateral.
• A personal guarantee.

Generally speaking, business brokers see terms which give the seller the right to take back control of the business within 30 or 60 days of missing payment. However, the biggest assets of many small businesses are intangibles, often referred to as goodwill (like customer and supplier relationships). By the time the old business owner takes back control, customers can be permanently lost and supplier relationships broken, making the business far less valuable.

For businesses whose operate with a substantial amount of inventory, there are sometimes clauses which require the new business owner to keep inventories at certain levels. In the case where the seller resumes control, they will at least not need to have to make a large expenditure on inventory.

Ideally, the seller would like the buyer to put up assets like real estate as collateral. There are several problems with this type of collateral. One, there is often a mortgage on the house. The bank holding a mortgage on the house has the first claim to the house. Second, there may not be much owner equity in the house after the mortgage is deducted. While the house could be sold even if the business collapses, that doesn’t mean there will be much money gained. Also, collecting against the collateral can be expensive.

Do deals with owner financing command a higher price tag?

Tom West of the Business Brokerage Press suggested that in deals where the business might attract a number of potential buyers, owner financing increased the sale value of the business by 10 to 15%. However, he emphasized that owner financing wasn’t really about obtaining a better price but, being able to close deals.

What legal and professional help should one get with seller financing?

In many transactions, there is a business broker involved. However, buyers should remember that the business broker works on behalf of the seller. Often buyers and sellers involve their lawyers and accountants (to value the transaction and go through the financials). Typically, there are several legal agreement that need to be drafted and signed including a Purchase Agreement (the terms of the sale of the business), A Promissory Note (the loan document), and a Securities Agreement (which describes what and how the lender can access collateral).

A Word of Caution From Josh Patrick

Before Josh Patrick became a well-known small business columnist for the New York Times and opened a wealth advisory service for business owners, he had a vending machine business. The business grew to around 90 employees when Josh decided to sell it.  The purchase price, which was in the millions of dollars, was paid 95% in cash, with 5% to be paid in the future. Shortly after the sale of the business, the new owner lost a major account and didn’t want to pay the 5%.  In the end, Josh was able to prove that the account was lost because the new owners left food rotting in a vending machine. With the investment of time and some legal costs, Josh recovered the money.

Mr. Patrick strongly believes that when the seller finances the sale, there is a high probability that the buyer will at some point decide to stop paying, as his personal experience suggests.  Because of the risks of seller financing, Josh advises sellers always try to get paid in cash, even it means taking significantly less money.