Should You Use Seller Financing to Buy a Small Business?
All You Need to Know About Seller Financing
Running a small business can be exhausting, and after a number of years, small business owners might want to cash out their profits and move on. At the same time, some aspiring small business owners might not have the time or patience for developing a startup, and might want to instead purchase an established business. Unfortunately, business loans for the purchase of an existing small business are hard to get. It, therefore, makes sense that one popular option for the purchase or sale of an established business is seller (or owner) financing.
What Is Seller Financing?
Seller financing of small businesses works much like owner financing in real estate transactions. Because most buyers don’t have the cash in hand needed to purchase a small business, they must find financing somewhere to complete the financing. Instead of a bank loan, the seller of the business works out an arrangement where the buyer makes monthly payments to them in exchange for getting ownership of the company.
Usually, the buyer will make a down payment, often a third of the value of the business, and then a sign a promissory note which outlines the total number of payments that are due over time (usually over the course of 5-7 years). The promissory note will also outline what will happen if they default on those payments, and what interest rate will be paid to the seller.
Pros of Seller Financing a Small Business
The main advantage of offering seller financing for a small business owner is that it makes the business more attractive to potential buyers. Because most buyers don’t have enough cash on hand and bank loans are hard to come by, a business offered for sale with seller financing is more attractive. So, for those who want to sell quickly, and for those who want to begin running a business without going through the startup phase and hassle of securing bank debt, seller financing makes sense.
Seller financing is also attractive to those selling their small businesses because they can generally receive a higher purchase price. The fact that they will receive payments over a number of years also gives them dependable cash flow, and reduces their tax burden since their capital gains are spread out rather than delivered in one lump sum.
Cons of Seller Financing for a Small Business
For the seller, the biggest con of seller financing is the risk involved. For this reason, it’s important that sellers take several steps to minimize the risk of default. First, make sure you’ve valued your business correctly to ensure you’re getting the best deal possible. Next, hire an attorney experienced in business sales to handle the contract and file any needed paperwork with the state. Make sure you’ve negotiated for all contingencies – late payments, default, breach of contract, and the transition plan.
Another potential con of seller financing is that the seller doesn’t have a clean break from the business.
Although the seller will no longer be involved in day-to-day operations until the loan is paid and the transaction complete, the seller is still an owner. In the event of default, this owner will need to take over the business once again. For sellers looking for guaranteed permanent retirement from the business, seller financing may not be the best choice.
What Kind of Buyer Is Right for Seller Financing?
Seller financing works better for some buyers and sellers than for others. In general, reliable buyers have some common characteristics. Most importantly, they come to the table with a full down payment in hand. Sellers should be wary of buyers who request that they waive the down payment. Reliable buyers will also come to the table with some sort of collateral, to avoid the need for a personal guarantee.
Sellers should also look for buyers who have the following:
- Some sort of business experience in the industry
- A track record of managing another small business
- A business plan for the business being purchased
- A clean financial record with no previous loan defaults or bankruptcies
No matter what small business you’re looking to buy or sell, the best way to ensure a successful result from seller financing is for both parties to consult with third-parties. The seller should work with an attorney in writing the promissory note, the buyer should have their own attorney review the note before signing, and both buyer and seller should consult with their financial planner or accountant to understand the tax implications of a seller-financed small business purchase or sale.