Updated: Jan 27, 2022
By Tsu-Li Liew
When a person wants to buy a business for sale, the buyer would usually need to have the money already or use loans to pay the price. Seller financing is an option that business owners can offer when selling their business. It also goes by “owner financing” and is another way that helps buyers fund their purchase.
Seller financing is used in sale of most small businesses today. Simply put, when a buyer wants to buy a business, instead of seeking out a loan from a bank, the buyer can ask the owner to provide the loan instead through seller financing. The business owner will get a promissory note from the buyer, which will describe in detail how and when the buyer pays back the loan. Investopedia defines promissory note as a written and signed promise by one party to pay another party, much like any other contract. Ownership of the business will then transfer over to the buyer when the deal has been closed, and the buyer will usually give monthly payments to the owner to pay off the amount that was seller-financed.
This option allows a business owner to widen their pool of potential buyers as well, increasing the chance of the business being sold. While it is mostly used in real estate transactions, seller financing is often used in the sale of small businesses as well. However, like any other type of transaction, there are advantages and disadvantages that a business owner should weigh for when offering seller financing.
Advantages of Seller Financing
There are many benefits of seller financing for both the business owner and the buyer. According to BizBuySell, these advantages for the owner include a higher chance of selling the business, a higher selling price, as well as profits from the interest of the loan. According to the BPE Law Group, the fact that seller financing cuts out the need for a lender is also another advantage.
If a business owner offers seller financing with the sale of the business, there is a higher chance that the business will be bought. Depending on the price of the business, sometimes buyers do not have enough funding and are not able to get loans to cover the rest of the price. In that case, the business owner will have fewer potential buyers who are able to afford the sale price. However, if a business owner is willing to offer seller financing, then there will be more interest in the business since people who might not have enough funds will be able to pay off the rest over a period of time instead. For example, if a buyer is only able to secure a loan of $230,000 when the sale price is $250,000, by offering seller financing, the buyer can get a $20,000 loan from the business owner. This way, the owner can sell the business and eventually get the loan paid back once the buyer takes over.
Another advantage of seller financing is that the business owner could potentially sell the business at a higher price. Instead of lowering the price to attract more buyers, the owner can offer seller financing to the buyer in order to pay for the business, whether for the full amount or to make up the difference as a supplement to other loans. This way, the owner is able to sell the business at a potentially higher price.
Seller financing can also cut out the middleman from the transaction, such as banks and other financial institutions that provide loans. Cutting out the middleman can also shorten the time needed to close the transaction. If the business owner finances the entire loan for the buyer, the buyer will not be required to wait for a bank to process and approve his or her loan application. Seller financing also provides a payment method for buyers who otherwise might not be eligible for a bank loan due to bad credit, since the business owner does not need to check a buyer’s credit. Instead, the parties can agree on the terms of the promissory note. By cutting out the middleman, the buyer can also save on costs that would normally be incurred when dealing with a bank. This might make a buyer more willing to buy the business as well, since they will be dealing with one less party in this transaction.
Seller financing provides many additional benefits to the business owner as well when it comes to negotiating the terms of the promissory note. Since the business owner is providing the loan, they can set the price of the down payment as well as the rate of repayment. Of course, it is important to remember that the terms should be fair and reasonable to the buyer. Otherwise, a bank loan would be better for the buyer than seller financing. According to Investopedia, a down payment for seller financing might be around 20% or more.
One of the biggest benefits to the business owner offering seller financing is the money he or she can earn from the interest of each repayment. Since the owner is the one providing the loan to the buyer, each time a buyer makes the agreed-upon payment for the loan, any interest will go to the owner instead of a bank.
Disadvantages of Seller Financing
Before offering seller financing, a business owner should be aware that there are always disadvantages in any transaction. Despite the many advantages of seller financing, a business owner should also know the risks that are specific to offering this type of loan. These risks include being connected to the business for a longer time, the buyer defaulting, and others. Seller financing also uses up a business owner’s money. This may lock the owner out of other investment opportunities that will have to wait until the money is fully paid back by the buyer.
Often, seller financing is also used as a last resort for selling a business, in order to attract different buyers who were not able to afford the price. Therefore, an owner needs to be careful when selecting a buyer who will rely on seller financing. If a buyer is not able to get a loan through a bank, this might raise a red flag since banks are usually strict on who can get a loan. An owner should determine whether a buyer will be capable of repaying the owner’s loan or whether he or she might default on paying it back. An owner offering seller financing will have to be more diligent in selecting a buyer in comparison to an owner who does not offer seller financing.
When putting up a business for sale, an owner probably wants to sell it as soon as possible in order to enjoy other opportunities or their retirement. However, seller financing does not give them this luxury. Since the owner provided the loan, he or she will still be involved with the business, as the loan repayment will be tied to the success of the business. The length of involvement will depend on the terms of the promissory note. An owner should be prepared to act as a mentor to the buyer as they take over the business, in order to keep the business afloat.
If the buyer is not able to keep the business running due to their inexperience, lack of skill or inability to connect with the customers, then the buyer will not be able to make any profits. The lack of profits could result in the buyer defaulting on the payments. In this case, the owner will be able to take control of the business again through a foreclosure. However, the owner will need to pay for a lawyer to handle the foreclosure and to evict the buyer from the business. If the owner successfully evicts the buyer, they will have to repeat all the steps and find a new buyer. This might be burdensome for an owner who wanted to sell the business and be done with it.
How to Prepare for Seller Financing
While seller financing is an option that business owners offer as a last resort to sell their business, there are still many advantages listed above that come from offering seller financing. Of course, these advantages will have to be weighed against the risks that come with offering it. It is up to an owner to determine whether offering it will be beneficial to them or whether the risks will be too burdensome. BizBuySell lists other do’s and don’ts of seller financing, on top of weighing the benefits and risks.
Once an owner decides to go ahead with offering seller financing, it is important that any advertising for the sale of the business mentions it as an option. Otherwise, the owner will not be able to reap the benefit of attracting a larger pool of buyers. An owner also has to be sure that they are willing to fund a buyer, since new potential buyers will most likely need seller financing in order to buy and take over the business.
While one benefit is cutting out the middleman, it is highly recommended that the parties hire an attorney or other professionals to draft the promissory note. This will ensure that nothing will be left out of the note. It is possible for an owner to draft the note without professional help, but it increases the risk of an important term being left out and may lead to future disagreements between the owner and the buyer. Hiring a professional to draft the note could prevent future problems and also save the owner the cost of a potential lawsuit.
Even though a buyer can avoid going to a bank for a loan, an owner should try to avoid funding the whole purchase price with seller financing. A larger down payment of 20% to 50% can minimize this risk, and an owner should not waive the down payment in order to make a sale. Even then, the owner should try to decrease how much of the sale price will be seller- financed. The more the owner commits to the business, the higher the risk of defaulting will be, as the owner will be relying on the revenue of the business sold in order to get paid back. Since the business will have a new owner, it is up in the air whether it will do well or not. Therefore, getting more money upfront and offering less seller financing will reduce this risk.
Another important point is that an owner should be comfortable taking on this commitment, and not be pressured by a buyer into seller financing a transaction. A buyer might push hard for seller financing if they are not able to get a loan from a bank. However, an owner still has the power to decide if he or she is willing to offer it when negotiating the transaction with the buyer. Even if the owner really wants to sell the business, he or she should be comfortable with an offer of seller financing and not rush into the commitment without assessing the risks.
Seller financing offers a solution for an owner to increase the chances of selling the business, while also giving opportunities to buyers who may otherwise not be able to afford the sale price. Instead of using it as a last resort, business owners can see it as an investment opportunity, if they are able to find a reliable buyer.
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