Business owners who are planning to sell have a lot of important decisions to make. Whether to offer seller financing should be close to the top of the list. Over half of small business purchases involve some degree of seller financing, but some business owners are still hesitant to embrace the trend. If you fall into that group, it’s time to learn what you need to know about seller financing and how it can help sell your business. This article explains how seller financing can help you sell your business.
What Is Seller Financing?
Also referred to as both seller carryback and owner financing, seller financing allows business sellers to basically act as the bank, or, more often, a secondary form of financing in addition to the bank. The form of seller financing has a wide spectrum. In rare cases, the buyer puts down a down payment, then the seller offers a loan to cover the rest of the purchase price. The buyer then repays the loan in installments, with interest. This may sound a little odd, but it’s a very common practice in business sales. More often, the Buyer finds a bank, usually in the form of an SBA loan for deals less than $5 million, puts down some equity, usually 10% – 15%, and asks the bank to finance the rest. Or, the Buyer may ask the Seller to finance a piece of the purchase price, usually 5% – 30%, in addition to the equity down payment and the bank financing. Many buyers feel this incentivizes the Seller to not sell them a dying business. Buyers should know that in more competitive deals, the seller financing may be closer to the 5%, or even 0%, compared to the 30% mentioned above.
How Seller Financing Works
When business owners offer full seller financing, they can remove the middleman by cutting out the bankers and working directly with buyers to figure out a mutually beneficial financing plan. Sellers usually allow buyers to finance no more than 60% of the sale, but the details vary from case to case. More often, sellers demand much more than this, up front, and hence, why a bank is usually involved. The Buyer may still ask for some percentage of the purchase price to come in the form of seller financing, even if this comes at a higher interest rate from the Seller, since the Seller is in “second-lien” position, compared to the bank.
The Importance of Due Diligence
Just like banks, business owners who want to offer seller financing must perform some due diligence to ensure that the buyers will be able to run the business efficiently enough to allow for on-time payments. To that end, you should ask for relevant information such as a resume, personal financial documents, and other paperwork related to finances and business experience. It’s also appropriate to ask the buyer about his or her intended business plan.
Just like a bank, you can pull potential buyers’ credit histories and maintain the right to deny financing to those who don’t meet reasonable criteria. It’s also commonplace for business sellers to charge higher interest rates and require larger down payments and/or collateral from buyers who have lower credit scores.
Seller financing terms are usually finalized during initial negotiations, and every deal is unique. That said, it can help to know how other business owners have handled similar financing situations.
Most sellers will finance up to 0% – 30% of the selling price, depending on the perceived “riskiness” of the business and its continued operations. However, in more rare instances, some sellers offer to finance larger portions of the asking price, either due to ignorance around what a bank will provide, or due to the business having larger risks. In these cases, it is possible that a bank would not be willing to finance the purchase. Buyers should also be aware of the concept of ‘adverse selection’ when a seller offers to seller finance a large portion of the purchase price. Is the Seller happy to get 40% or 50% of the purchase price because they know the business is failing? It has been our experience that the better the business, the less the Seller is willing to finance.
The average seller financing arrangement has a term length of between five and seven years. Again, though, there are no steadfast rules here, regarding how seller financing can help you sell your business.
The Small Business Administration (SBA) charges interest rates of between 7.25% and 9.75% for small business loans. Seller financing is a bit more variable, but most sellers charge interest rates that are a bit higher than this, since they are in second-lien position. This is called mezzanine financing at the lower-middle market level and above and can involve outside, specialized mezzanine finance companies.
Most banks request down payments of between 10 and 25 percent of the loan amount. This can be higher when a bank is not involved.
How Sellers Benefit From Offering Owner Financing
Now that you have a better idea of what seller financing entails, it’s time to discuss why you might want to go to all the trouble. While seller financing won’t necessarily change the asking price or selling price of your business, it can help you in other ways.
1. Greater Likelihood of Making a Deal
Business brokers know how essential seller financing can be to completing transactions, which is why they usually recommend it to clients. Offering owner financing lets you widen the scope of potential buyers, increasing the sale’s likelihood of success and reducing the amount of time that the business is on the market.
Business owners who plan to offer some seller financing shouldn’t list their businesses with unreasonably high asking prices, but they are more likely to get close to the asking price instead of having buyers negotiate down. This benefit is due to the greater levels of demand for owner-financed businesses.
Business deals that involve only seller financing tend to close faster than those requiring bank loans. The approval process for bank loans tends to be lengthy, whereas seller-financed deals can go through as soon as the seller decides to approve the buyer for financing and some legal paperwork.
Seller financing may not change the value of a business, but it will generate some extra cash for sellers in the form of collected interest. The real value of the money business sellers make off of interest varies significantly, depending on market interest rates.
Offering owner financing also allows sellers to spread their taxable income over a greater number of years. Reporting incremental gains instead of large sums can lower income taxes.
Benefits for Buyers
Offering seller financing can open up options for aspiring business owners who may not be comfortable with the industry or past operations of a business. Of course, you shouldn’t approve anyone who seems unlikely to be able to run the business successfully and turn a profit. However, most seller-financed loans still have more lenient financial requirements.
Business buyers can also benefit just as much as sellers do from the faster closing times associated with owner-financed deals. Instead of completing multiple layers of approval at a traditional bank to get access to their funds, which can take up to six months, buyers can simply offer all of the requested documents to sellers and get approved quickly.
However, buyers should be aware of adverse selection. A business in demand will lower seller financing amounts, many times to 0%. Seller financing may also have higher interest rates than traditional bank financing. Plus, buyers may accomplish what they truly desire, such as reasonable training by the Seller by having escrows, instead of seller financing.
Is Seller Financing Really Necessary?
You don’t have to offer seller financing if you plan to sell your business, but there are good reasons that experts recommend doing so. It can open up new opportunities not just for buyers but also for sellers who want to close deals quickly and get something closer to their asking prices, if it is a solid business.
If you’re not sure whether to offer seller financing, the best thing you can do is speak with a business broker. These industry experts know exactly what it takes to sell a business, and they’ll be able to offer personalized help.