Seller financing arises when a buyer either asks for the seller to be paid overtime (instead of receiving a cash payment for the full purchase price at closing) at the outset of the transaction or if the buyer determines during the course of negotiation or before closing that the buyer cannot obtain financing from a bank or another lender.
The failure of the buyer to get financing is a very common reason for transactions not to close. While some assume financing is the buyer’s problem, if a seller really wants to get a deal done, the seller may need to provide the financing for the deal to be completed.
Step 8. Seller Financing
Generally, about an estimated 50% of all acquisitions of businesses with an enterprise value of less than $25,000,000 require some form of seller financing. The reason? It may be difficult to get bank financing for an acquisition of a business with relatively small annual revenues and relatively small asset values. The lending bank may be unwilling to lend the full purchase price based on the asset value or the cash flow. Sometimes buyers do not have sufficient credit worthiness for a loan (which might make you rethink the sale to that buyer). In any case, if the bank won’t lend enough money to a buyer to purchase the business, the buyer will need to bring additional equity (cash) to the table, find third-party subordinated debt or another financier, or the seller will need to finance the shortfall.
Seller financing usually involves the seller “carrying” all or part of the purchase price through a promissory note with the company, so the company pays the note to the seller over a period of time. The note may be interest only, with a balloon payment at the maturity date. Or it may require amortized payments of interest and/or principal, depending on the circumstances. The note may have provisions for pre-payments or additional payments if certain revenue levels are met. The seller may retain a portion of the company stock subject to a mandatory purchase at some future date.
Pros and Cons of Seller Financing
The seller will need to coordinate with any bank lender as to the relative priority and collateral of the seller carry-back financing. The seller financing note will almost certainly be subordinated to bank debt, which causes additional risk and may result in payment delay for the seller. Seller retention of an equity interest will likely disqualify the buyer from SBA loans.
Beyond technicalities, the seller must decide if they really want to take the risk of carrying the seller financing. The buyer’s bank has already said they won’t take that risk.
When Seller Financing is the Only Option
Carrying some financing may be the only way you can sell the business in a distressed situation. Or it may be the only way you can sell to a favored buyer (a family member, an employee group).
What to Consider When Using Seller Financing
When considering seller financings, all parties need to make a realistic assessment of the risks and agree on terms to contain or mitigate these risks. Sellers should consider the buyer’s business and personal balance sheet. A personal guarantee, subordinated to senior bank debt, might not be worth much as a practical matter.
Careful drafting of the purchase agreement and note provisions is critical. Perhaps more important is the seller having the trust and confidence in the buyer’s ability to operate the business.
With the seller financing component behind us, in the next part we will discuss managing the transition for a successful sale and ongoing business.