The Impact of Seller Financing

A few years ago, we were able to negotiate terms for the sale of a small retail business to a buyer who was interested in expanding.  The business was a challenge to sell, with the owner working full time in the business and generating only enough cash flow to pay himself at about 50% of minimum wage.  In reality, the owner was paying himself nothing for years, trying to keep the business afloat, and had much more invested in the business than it was worth.  Nevertheless, we identified a prospective buyer who offered to purchase the business with seller financing, paying only about 5% of the purchase price in cash and the balance to be paid in installments over 4-5 years.  The annual payments to the seller would total more than twice the owner’s historical cash flow, every year for several years, with the owner not having to work at all after a short transition timeframe of 30 days.  The buyer had sufficient personal assets and was willing to personally guarantee the seller financing, which was not a tremendous amount of money.  We felt that the terms were more than fair and highly recommended the structure to the seller.  The seller rejected the offer, on the basis that he simply did not want to offer significant seller financing, and the business was not sold.  Ultimately the greater risk seems to have been refusing to offer seller financing, since the business eventually closed.

                  It is common for business owners to reject the idea of seller financing, or at least at any significant level.  (Ten percent seller financing is actually quite common, as it helps to bridge the buyer equity requirement for SBA-guaranteed financing.)  There are, of course, valid reasons why a business seller should be wary of financing the buyer.  For one, the business will be in the hands of the buyer and the primary source of cash flow to repay the financing will be out of the seller’s control.  Occasionally thieves have been known to acquire equipment or other tangible assets of a business with 100% seller financing, after which they liquidate the assets for cash and disappear, leaving the business in shambles.  While these schemes are rare and can be avoided with careful planning, they do mandate seller caution. 

There is also much to be said in favor of a buyer who has skin in the game, meaning that they have committed significant financial assets or credit to the transaction and have a strong incentive to be successful.   Business owners know that successfully running a business requires a great deal of commitment and personal sacrifice, and a buyer who is not willing to commit at that level may not be able to continue the seller’s success.  In other cases, the seller may be limited in his ability to offer seller financing by existing debt secured by the assets that must be satisfied on sale.

                  Despite the legitimate concerns of sellers on the topic of seller financing, there are several very good reasons to offer seller financing at a significant level.  For one, seller financing at a level that replaces lender financing (for example, 80% of the sale price) will reach a far greater pool of prospective buyers.  For some types of businesses (for example, restaurants and gas stations), getting any type of bank financing is challenging at best, and seller financing may be the only way to finance the purchase.  Oftentimes the only alternative to seller financing for these types of businesses is a cash buyer, and cash buyers are not plentiful in the market for small businesses, nor do they feel compelled to offer top dollar.  Investors demand a higher return on equity than secured lenders, and as a result a cash buyer will be willing to pay substantially less for a business than a buyer who obtains financing.  The seller who offers financing will see many more prospective buyers, and more prospective buyers should mean a higher sale price.  At least one experienced business appraiser has suggested that seller financing in lieu of buyer cash can easily increase the sale price of a business by 50% of the amount of seller financing provided, above an all-cash price.

                  Another advantage with seller financing is that the sale and closing process may be expedited by months, given the typical loan closing timeframe, and involvement of commercial lender financing can actually cause some transactions to fail after the seller and buyer agree to terms.  A business appraisal, and possibly equipment or real estate appraisals, will be required for most commercially-financed transactions.  If the appraisers’ values come in less than the contract values agreed by the seller and the buyer, adjustment to the terms – including sometimes a lower contract price – will be required for the transaction to close.  Buyers who purchase with seller financing will rarely incur the expense to obtain appraisals, just to confirm values to which they have already agreed.  As the financing process drags along and perhaps an appraiser or accountant for the lender or the buyer questions the pricing, some transactions will ultimately fail.  The seller should also consider that the commercial lender will be in first lien position on all assets of the business, meaning that little or no collateral position may be available for whatever lesser degree of financing the seller agrees to provide.  These are all risks related to commercial financing that the seller should consider alongside the risk of offering significant seller financing.

                  There are a few more obvious, tangible benefits associated with seller financing.  For one, seller financing typically generates interest income, and the rate of return on seller financing can provide an additional source of income to the seller.  A seller receiving cash at closing must pay taxes on the proceeds and then invest the remainder to generate a return, and many of those investments also carry risks.  Some sellers will be more comfortable with obtaining interest income from the ongoing operation of a business they know well (particularly if they have a high level of comfort with the buyer, perhaps a former manager), as compared to a new, unfamiliar investment.  Second, installment sale reporting and payment of taxes stretched over a number of years can be attractive to a seller, when available.

                  Aside from saving the time, hassle and transaction costs of commercial financing, perhaps the greatest advantage of seller financing from the viewpoint of a buyer is the confidence and commitment it requires of the seller.  The buyer will have an increased level of confidence in the quality of the business purchased if the seller is willing to finance the transaction at a high level, knowing that the primary source for payment of the loan will be cash flow of the business.  Further, the buyer knows that the seller will have an ongoing commitment and interest in the buyer’s success or failure, for a relatively long period of time.  This commitment on behalf of the seller will help to assure the buyer that the seller will not disappear shortly after the sale, and that the seller will be willing to provide ongoing assistance and advice to guide the buyer toward success.  While the ongoing commitment may not be something the seller wants, just the assurance of seller confidence in the business and the buyer’s future success can deliver an enhanced selling price to the seller.

                  A number of precautions should be taken by the seller who has decided to offer seller financing.  The buyer should have enough at stake in the acquisition that the seller feels protected against fraud, and that the buyer is fully invested mentally and emotionally, if not financially.  A good starting point for minimum cash investment is the amount the seller could obtain in cash by liquidating the assets of the business, and the seller can easily justify that there is no reason to accept less in cash from the buyer.  A business with strong cash flow and easily financeable will require less seller financing in order to interest buyers, compared to another that is not eligible for commercial financing and will require either a buyer with buckets of cash or significant seller financing.  An individual buyer, husband and wife, or a business entity with a strong balance sheet should be required to personally guarantee the financing, meaning that if it is not paid by the buyer (usually a newly-organized corporation or LLC with little or no assets), they will be personally responsible.  This is important for dual purposes, assuring both a source of payment and that someone will have a personal financial stake in seeing to the success of the acquired business. 

A seller providing the primary source of financing should obtain a first lien mortgage or security interest in the assets of the business, allowing recourse to the assets of the business if the debt is not paid on time.  Real estate is a great source of collateral since it will tend to hold its value in the hands of a buyer, so a seller may be willing to provide more aggressive levels of seller financing secured by real estate.  Periodic financial reporting and maintenance of key financial ratios are techniques commonly used by commercial lenders to monitor the health of a borrower, and could be used in appropriate circumstances.  Most importantly, the seller should gain a high degree of comfort during the due diligence phase that the buyer to whom financing is offered will be successful in the business, since the business is usually the primary source of repayment.

                  Seller financing is not appropriate in all transactions, and it is virtually a necessity in other situations in order for the business to be sold.  Nonetheless, a good argument can be made that at least some amount of seller financing should be offered in most business sale transactions, for the benefit of the seller as much as the buyer.  The seller who agrees to seller financing will inspire greater confidence in the buyer, who knows that the seller will remain interested in her success.  Confidence lowers perceived risk, which in turn results in buyers willing to pay a higher price for the business.  Financing the transaction as primary lender may not be interesting to most sellers, but the benefit of offering some seller financing should be considered carefully.