What Is Seller Financing and Why Is It So Common When Selling A Small Business?

So just what does seller financing mean? And how does seller financing work for a business? 

Traditional banks are one source of financing when a small business owner sells their company. But when you dig into the numbers, working with a local conventional bank is less likely when the business is worth less than $3,000,000. Approximately 95% of small businesses have less than $5M in revenue and fewer than ten employees. Many of these businesses have a value between $250,000 and $2M. For these companies, often called main street, or micro-businesses, setting a valuation can be tricky. The lack of data available for the value of similar companies sometimes makes valuation challenging. Why? Well, much of this has to do with the fact that there is no requirement for tracking the sale price when these businesses change hands. These are private transactions. Even if the seller records the sale price in their tax return, it isn’t public information.

So how do buyers pay for a business when the sale price is between $250,000 to $2,000,000? Let’s take a look at some options. The following article explains seller financing and why it is so common when a buyer purchases a main street business.

Professional Buyers Or Investors Versus Individuals

A professional buyer is an individual or entity that acquires businesses primarily based on the financial profile. They are seeking a minimum amount of cash flow (profit). They may plan to grow the business and sell at a higher valuation within the desired timeframe (say 5 to 7 years). In some cases, the buyer may not be the actual operator of the business and will hire and install a team to manage the company as a part of their investment vision.

To make financial sense, the business needs to have enough cash flow and growth potential to support the investment model or provide returns to investors. Unfortunately, this often rules out companies with less than $5M in annual revenue – even more, if under $2M per year.

A buyer will want to have more than a financial profile to evaluate the opportunity for buying a company with less than $5M in revenue. Of course, the purchase has to make business sense. However, the buyer may be an employee or business partner planning to keep the business going after an owner exits by selling.

What About An SBA Loan To Acquire A Small Business?

The Small Business Administration or SBA supports small businesses in the United States by offering counseling and other educational resources, such as disaster relief and different types of loans to small businesses. An SBA loan to acquire a small business will require the buyer to inject 10% of total costs into the acquisition. Additionally, the SBA will ensure the business has enough money available – working capital – for the new owner to meet basic operating costs once they take over. For example, suppose the buyer desires a $600,000 purchase price and $200,000 of working capital/operational expenses, totaling $800,000. This would result in an $80,000 equity injection. Fortunately, half of this equity injection can be covered by the seller agreeing to finance participation (see below). A breakdown of the project costs could look something like this:

 

Table

 

 

The equity injection can come from a couple of different sources:

  1. Funds not borrowed, like gifts, savings, 401K, stocks, etc.
  2. Borrowed funds outside of the business, IF repayment can be proven. 

 

What Is Seller Financing For a Business? Why Is It So Common With Small Business Transactions?

In most cases, the buyer does not have enough proceeds to pay for the business upfront. In the example above, the buyer cannot provide $600,000 in cash to acquire the business or a $100,000 ‘down payment.’ This can create a challenge even when there is a willing seller and buyer that agree on the business price. 

To resolve this, the seller may agree to finance the transaction by having the buyer pay the acquisition price plus interest over time, typically several years. With an SBA loan, seller financing can account for up to half of this injection amount. That is if the seller puts their loan on full standby for the life of the loan, which means no payments of principal or interest until the buyer pays off the SBA loan.

But what if the requirement of a 10% equity injection disqualifies the buyer for an SBA loan? In the example above, that would be $80,000 and could far exceed what a buyer can afford. In this situation, the seller could finance the entire loan amount. The loan is “captured” in a loan agreement and referred to as a “note.” 

Seller Financing Terms

 A seller-financed loan agreement should include the following information:

  • The final sale price of the business
  • The interest rate on the loan and how it is calculated
  • The total amount being financed
  • Term or period over which the loan will be repaid (months, years, etc.) 
  • A schedule of the payments (monthly, quarterly, annually)
  • Any upfront payment or down payment the buyer will make
  • If the buyer is securing the loan or part of the loan with any collateral
  • What happens if the buyer is late on any payments
  • What happens if the buyer defaults on the loan or cannot pay it in full
  • The process to resolve any disagreements related to the loan (mediation, arbitration)

You should have an attorney draft, or at the very least, review any loan agreements. They know how to structure a seller financing deal.  

An attorney can ensure the total financed amount and payment schedule are accurate and achievable. A buyer will likely use earnings from the business to pay the loan. They will need to have enough money to cover operating costs, salaries, and the ability to invest back into the business. Yes, repayment is the goal, but neither side wants the payments to restrain the business. Additionally, it wouldn’t be productive to create a situation where the buyer cannot maintain the repayment commitment over a long time.

Now that you know what seller financing is and how it works, you can see why it may be an excellent solution for both seller and buyer. Sometimes an SBA loan or other bank loan isn’t an option.

Final Thoughts

It does carry some risk for the seller. Both sides need to be clear about the seller’s financing terms. Determine what sort of involvement the seller will have after the sale. The seller can be a great help to ensure the business continues to perform well enough to pay back the loan. Discuss these terms upfront. Addressing this in the loan agreement or purchase agreement to help avoid conflict down the road.