When selling your business, offers will come in many different shapes and sizes. In addition to differences in value, the structure from deal to deal can vary significantly. In most cases sellers are enticed by all cash transactions, but that option is not always in the offering. There are plenty of machinations that will come your way from potential buyers, including partial cash payments, earn outs and seller financing.
For now let’s focus on the last option – seller financing. Seller financing, as defined by Investopedia, is an “agreement where financing provided by the seller is included in the purchase price.” Simply said, the seller becomes a de facto note holder on the business once it transitions ownership. In most cases the interest tied to the seller note is higher than market rates – can be a point or more higher – and the security on the note is the business.
Why Seller Financing?
You may be wondering why a seller would want to finance the purchase of their own business. There is no standard answer for this question, but in many instances the seller note is a way to generate a higher purchase price.
The buyer may not have enough cash on hand to provide the seller the price they are seeking at the close of the transaction, so they are able to bridge the gap by providing cash at close and then paying the seller the additional funds in a note with interest. If the lower amount of cash at close is sufficient, this can be a way for a seller to receive a steady stream of cash for an extended period of time.
Seller financing can also be used in cases where the buyer is unable to get traditional bank financing. It also can speed up the transaction because there is a far more truncated underwriting period.
Due diligence is critical when carrying a seller note. Sure, the note is secured by the business you spent years growing and developing, but the last thing you want after the close of a transaction is to have to go back to work and begin the sale process over again.
The diligence process will be similar to the process the buyer performs on your company. You will want to understand the buyer’s credit profile, financial statements, debt burden and any other pertinent financial information.
In working with a business broker or investment banker, most seller-financed transactions include contractual language that enables the seller to take the business back in 30 to 60 days if the financing does not go through. Other contractual stipulations are also typically included, such as minimum inventory levels required by the seller during the seller note repayment period.
Buyers and Seller Financing
Many buyers prefer transactions that involve seller financing. When a seller shows that they are open to providing seller financing they are showing potential buyers that they believe the business is healthy and will continue to provide enough cash to service the debt a seller note will generate.
There is no standard term for a seller note, but they are typically not shorter than two years and not longer than five years. They can be shorter and can be longer, but that is not common. In most cases your investment banker or business broker will work with you to make the note as short as possible while paying as much interest as the buyer will accept. Typical interest rates range from prime to prime plus one point. The amount of the purchase price financed in a seller note is generally not more than 60%.
Seller financing can be a creative and efficient way to ensure a transaction is closed, and it also provides incentives for both the buyer (less cash at close or need to qualify for bank financing) and seller (collecting steady cash flow plus interest).