M&A Seller Financing: A Complete Guide

Introduction

One of the simplest ways to finance the acquisition of a business is to work with the seller to negotiate some form of seller financing, which is called a “seller note.”

The vast majority of small business sales — 80%, according to industry statistics — include some form of seller financing. Most M&A transactions in the middle market include some component of seller financing but the amounts are low — often 10% to 20% of the deal size.

Seller financing is often the most suitable option if SBA financing cannot be obtained. Seller financing is also faster to arrange and requires less paperwork than traditional financing sources.

We answer the following questions in this article:

• What are the benefits of financing a portion of the sale?
• How can I protect myself from the buyer not paying?
• What interest rate is fair to charge? How many years should the note be for?
• How do I know how much to finance?
• Why should I use a third-party loan processor?
• Should I remain on the lease?
• Can I sell the note if I need cash?
• Should I offer seller financing for the sale of my business or wait to see if the buyer requests it?
• What if I am looking for all cash but might finance the deal for the right buyer?

If you are involved in financing an acquisition for under $10 million, you need to keep reading.

What is Seller Financing?

With seller financing, you receive a down payment and then periodic (usually monthly) payments until the buyer pays you in full.

For example, if the purchase price is $5,000,000 and the seller is willing to finance 50% of the purchase price, the buyer puts down $2,500,000 and makes monthly payments on the remainder until the remaining balance of the seller note is paid in full.

You should decide early in the process of marketing your business whether you will offer seller financing. This is because one of the most important components of the business sale is how the buyer plans to finance the transaction. One of the first questions buyers have is whether or not you will finance a portion of the sale.

Because the seller is functioning as a bank, you can expect the seller to prequalify the buyer before committing to financing the sale. The seller may prequalify the buyer by obtaining a copy of the buyer’s credit report, a resume detailing the buyer’s previous business experience, and, in some cases, even hiring a private investigator. The buyer may also offer their personal assets as collateral, in addition to the assets of the business.

Most sellers of small businesses want a minimum down payment of 50%, and most sellers offer terms ranging from three to seven years; however, the terms must make sense financially for both parties involved.

For middle-market businesses, these deal structures usually include a seller note amounting to 10% to 30% of the purchase price.

You can also expect the seller to:

• Require that the buyer meet certain specifications or financial benchmarks after closing, such as maintaining a minimum amount of working capital or inventory
• Request access to financial statements during the term of the loan
• Remain on the lease during the duration of the note

What are the Benefits to the Seller of Financing a Portion of the Sale?

• Lower taxes: The seller doesn’t pay taxes until they receive the money. Be sure that the note is structured so it is “non-negotiable.”
• Higher selling price: Businesses that include seller financing sell for 20% to 30% more than businesses that sell for all cash.
• Faster sale: Businesses offered with seller financing are easier to sell than a business offered for all cash.

What is an Amortization Period?

When referring to buying or selling a business, amortization refers to paying off debt, in installments, through a fixed repayment schedule. Or, plainly stated, amortization is the process of paying off a loan over a period of time.

For example, let’s say you purchase a business for $10,000,000 and have a down payment of $7,000,000. If you take out a loan for the remaining $3,000,000, which you will repay monthly, plus interest, you will be required to pay the interest on the loan plus a fixed amount of principal.

If you are paying off this loan in equal installments over the life of the loan, your debt is amortized.

A majority of your monthly payment at the beginning of your loan goes to interest, with the remainder going toward the principal.

The farther along you are in paying off the debt, the more of the payment goes toward the principal. In our example above, if the debt is amortized over ten years, your monthly payments for the $3,000,000 loan would be approximately $33,000 per month. Most of this would go toward interest initially, but toward the end of the amortization period, most of the $33,000 is going toward principal, resulting in the debt being paid off in the planned time of ten years.

How Can I Protect Myself from the Buyer Not Paying?

Because you are financing a portion of the sale, you should think and act like a bank and qualify the buyer before committing to them. We recommend obtaining a detailed financial statement, credit report, resume, and any other pertinent information you can get from the buyer as early as possible in the process. You should also select a buyer you think will succeed in your business from an operational standpoint.

If the buyer of your business is another company, then ask the buyer about their previous acquisitions. Talking to the owners of companies they have acquired in the past may also be helpful. Depending on the size of the company, it may be prudent to perform due diligence on the principals of the company that wants to acquire your company.

Most of the problems we see related to seller financing originate from the seller accepting a low down payment. We consider a low down payment to be anything less than 30%. We suggest asking for a down payment of at least 30% to 50% of the asking price. Why? Few buyers will walk away from such a large down payment.

Are There Any Other Ways I Can Protect Myself?

A strong promissory note should be drafted with clauses that directly address non-payment and late payments.

A Uniform Commercial Code (UCC) lien should also be filed on the business, preventing the buyer from selling the business or the assets during the term of the note.

If the buyer is an individual, you may also be able to negotiate to collateralize the buyer’s personal assets in addition to the assets of the business; however, doing so can sometimes signal to the buyer that you do not have faith in your business. We customarily draft these documents when we handle a closing, although an experienced escrow agent or attorney can also draft these documents.

Additionally, you can require the buyer to maintain specific financial benchmarks post-closing, such as maintaining a minimum inventory level and working capital or specific debt-to-equity ratios. We also recommend that you have access to monthly or quarterly financial statements. This should enable you to spot and help correct problems early on.

How Can the Buyer Motivate the Seller to Finance the Sale?

Because the seller is financing a portion of the sale, the seller will think and act like a bank. When you are the buyer, we recommend providing the seller with a copy of your detailed financial statements, credit report, resume, and any other pertinent information on yourself as early in the process as possible.

If you represent a company, document your previous acquisitions. Allowing the seller to talk to the owners of companies you have acquired in the past may also be helpful.

What Interest Rate is Fair to Charge

Over the past 10 years, the interest rates charged on promissory notes have ranged from 6% to 8%. The rate depends on the amount of risk involved and less on the current cost of money.

Some buyers state that current interest rates on residential real estate mortgages are much lower and that the rate should be competitive with these. We explain to buyers that such a loan is risky for the seller and little collateral is available, other than the undervalued assets of the business. If you default on your mortgage, the bank simply takes your home back. However, if you default on a loan used to buy a small business, there often isn’t anything to take back other than a struggling business.

Other factors that should be considered in determining the interest rate to charge include the total price of the business, the buyer’s credit score, the buyer’s experience, the buyer’s financial position, and perhaps most important, the amount of the down payment. The interest rate is more a function of the risk than the current cost of money.

How Do I Know How Much to Finance?

Your decision regarding how much to finance must make sense from a cash-flow standpoint — if your business makes a profit of $100,000 per month, then a note of $90,000 per month won’t make sense. The profit from the business must cover the amount of the note and also pay the buyer a living wage. If it can’t, then it won’t work.

The following information is based on statistics from more than 10,000 business sales:

• Average interest rate: Ranges from 6% to 8%, but there’s a slight variance. This is based on risk, not prevailing interest rates. Financing a business is risky; hence the relatively high rates compared with interest rates on other assets in the market.
• Average length of note: Five years, but it varies from three to seven years.
• Average down payment: Usually 50%, but it varies from 30% to 80%.
• All cash deals: Less than 10% of businesses sell for all cash.

Why Should I Use a Third-Party Loan Processor?

We recommend using a third party to service the loan. A loan processor handles all aspects of collecting, crediting, and disbursing monthly loan payments. As a neutral third party, they simplify the day-to-day management and process of managing loan payments. Using a third party to administer the payments simplifies recordkeeping.

Should the Seller Remain on the Lease?

As the seller, make sure you remain on the lease during the entire period of the note. If the buyer defaults, you will need to take the business back and repossess the lease.

Alternatively, you can negotiate to take back the lease if the buyer defaults without you remaining on the lease. In this scenario, you would not remain on the lease; however, you would retain the ability to take back the lease only in the event of a default by the buyer. Again, this should be addressed by an experienced broker or real estate attorney.

Can I Sell the Note if I Need Cash?

You can often sell the note after it has matured for six to 12 months. There are many investors who purchase these notes, which effectively cashes you out.

Unfortunately, it is often at a steep discount, but there are few alternatives other than selling your note. If you would like to leave this option open, it is important to ensure that the note can be transferred or assigned to a third party.

Should I Hire a Private Investigator?

If you are considering financing a significant portion of the purchase price and doubt the buyer’s credibility, you should protect yourself. Money spent on an investigation could save you hundreds of thousands of dollars down the line if you find out that your prospective buyer is a bad credit risk.

A private investigator can reveal information about individuals who want to purchase your business, such as aliases and undisclosed addresses. This information can help you determine the character of your buyer’s past and their creditworthiness.

In addition, a private investigator can help you learn if the potential buyer has any current or previous litigation, debts, or claims that could predict whether they would default on the loan to you. An investigation of their public records could help identify any undisclosed arrest records, bankruptcies, corporate records, court records, criminal records, deeds, or divorce filings.

It’s important to note that a signed release may be required by law to get this information. The buyer has a right to refuse the release, though they should understand your need to protect yourself if they are asking you to finance the loan. Explain to the potential buyer that it’s a necessary action, considering the financial risk you are taking. They would have to do the same thing with a bank or financial institution. Please consult your attorney for more advice.

What Documents Need to be Drafted?

You will need a promissory note and security agreement which address the key terms of the seller note. A uniform commercial code (UCC) lien on the assets of the business should also be filed post-closing.

Should I Offer Seller Financing for the Sale of My Business or Wait to See if the Buyer Requests It?

For small businesses, it’s best to offer specific terms when marketing your business for sale. This sends the message to the buyer that you have given the sale careful consideration and are serious and realistic in terms of the sale. Buyers like to deal with prepared sellers. You will also receive more responses if you market your business for sale with some form of financing versus for all cash.

For mid-sized businesses, it’s common to market a business without a price and without offering specific terms.

What if I Am Looking for All Cash But Might Finance the Deal for the Right Buyer?

In this case, we recommend mentioning in your ad copy that financing is negotiable. Don’t specify the exact terms under which you would finance the sale. This does not commit you to financing the sale; however, the mention of possible financing will not preclude buyers who are only looking at businesses in which the seller would finance a portion of the deal.

How Many Years Should the Note be For?

Most notes range from three to five years. Common sense is the rule of thumb here. The cash flow from the business should cover the debt service. Let’s look at a simple scenario:

Won’t work — debt service too high

Price of business:$1,000,000Down payment:$300,000Amount financed:$700,000Term:2 yearsInterest rate:8%Monthly payment:$31,659/monthAnnual payment:$379,908Annual cash flow from business:$400,000Minus annual debt service:$379,908Profit left over after debt service:$20,092

 This scenario obviously won’t work because the payment is 94% of the annual profit of the business. A more realistic scenario would be a four- to five-year term. Note that the term has a larger impact than the interest rate. The payment should be less than a third of the annual cash flow of the business. If the cash flow of the business is stable from year to year, then it can be higher. If the cash flow is inconsistent, you should build in some cushion room and structure the note so the payment is lower.

Can the Seller Note be Payable to Another Entity Other Than the Seller Entity?

The seller note can be made payable to another entity, such as a creditor of the seller. This may be done as long as the contract provides that payment to the entity is equivalent to the payment to the seller.

Can Payment on a Promissory Note be Made Directly to an Individual Owner Instead of the Entity?

Payment to the individual owner of a seller may be made as long as the contract provides that payment to the individual owner is the equivalent to making payment to the seller.

Summary

For small businesses: If you aren’t willing to finance the sale of your business, there’s probably another seller with a reasonably priced business that’s similar to yours who will. Sellers must consider financing the sale of the business if they’re serious about selling, especially if the business is not pre-approved for bank financing.

For mid-sized businesses: Most M&A transactions in the middle market include s0me component of seller financing, though the amounts are low, often 10% to 20% of the transaction size.