How Seller Financing Works When Buying or Selling a Business

How Frequent is

seller financing?

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%) of their closed sales include seller financing while another 32% noted that most (60 to 89%) included it.

The largest online marketplace for selling businesses, BizBuySell

Why is seller financing So popular?

Banks have two basic requirements when they make a loan: !1. Confidence in the borrower’s ability to

repay the loan. 2. Collateral to sell, if the borrower does

not or cannot pay back the loan.

Banks do not like to finance the purchase of small businesses

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?

1. The new owner’s lack of experience in running the business.

2. IRS tax returns show poor financial numbers.

3. The business does not count as quality collateral.

What prevents bank financing?

Let’s say that a business being sold is financially healthy. On paper, it looks like the business should be able to support payments. However, the past performance of the business is based on having an experienced owner.

1.

The new owner may not have that experience. In short, the management change makes banks reluctant to count on the business’s past performance.

1.

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.

2.

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.

2.

Lastly, there is the issue of collateral. Borrowing to buy a house 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. The bank should be able to get back all the money by selling the collateral.

3.

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.

3.

FranchisesThe Exception to The Rule

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.

New business owners are often

able to get financing

What percentage of the sale amount is typically

seller 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. However, there are no hard and fast rules for seller financing.

60 – 70% of the sale’s amount is typically owner financed

What are the typical terms

for owner financing?

The terms of the loan had as much to do with the buyer’s ability to make payments, as they did with market rates. 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.

5 – 7 years and 6 % – 10% Interest Rates

What protections do seller’s

try to demand in exchange

for financing?

1. Control of the business, if there is non-payment.

2. Real Estate as collateral. 3. A personal guarantee.

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

The right to take back control of the business within 30 or 60 days of missing payment. By the time the old owner takes back control, customers can be permanently lost and supplier relationships broken.

Business Brokers see terms which give the seller

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.

For businesses whose operate with a substantial amount of inventory

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.

Real Estate as collateral

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.

Real Estate as collateral

Do deals with owner financing command a higher price tag?

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, owner financing wasn’t really about obtaining a better price but being able to close deals.

Tom West of the

Business Brokerage

Press suggested

What legal and professional

help should one get with

seller financing?

However, buyers should remember that the business broker works on behalf of the seller. Often buyers and sellers involve their lawyers and accountants.

In many transactions, there is a business broker involved

Typically, there are several legal agreement that need to be drafted and signed including a Purchase Agreement, A Promissory Note, and a Securities Agreement .

In many transactions, there is a business broker involved

A Word of Caution

From Josh Patrick

There is a high probability that the buyer will at some point decide to stop paying. Because of the risks of seller financing, Josh advises sellers always try to get paid in cash, even it means taking significantly less money.

Mr. Patrick strongly believes that when the seller finances the sale

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