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M&A Seller Financing: A Complete Guide

Introduction

Discover one of the most straightforward ways to fund your business acquisition – through seller financing, commonly referred to as a “seller note.”

Statistics show that a substantial 80% of small business sales incorporate some form of seller financing. In the middle market of M&A transactions, seller financing remains prevalent, typically comprising 10% to 20% of the deal size.

Seller financing presents an expedient alternative when traditional financing options like SBA loans are unattainable. It offers a swifter arrangement process with significantly reduced paperwork requirements.

In this article, we provide insightful answers to the following key questions:

  • What are the advantages of financing a portion of the sale?
  • How can you safeguard your interests if the buyer defaults on payments?
  • What constitutes a fair interest rate, and how long should the note’s term be?
  • How do you determine the optimal financing amount?
  • Why should you consider enlisting the services of a third-party loan processor?
  • Is it advisable to retain ownership of the lease?
  • Can you sell the note for immediate cash if needed?
  • Should you proactively offer seller financing or wait for buyer interest?
  • What if you prefer an all-cash deal but are open to financing for the right buyer?

If you’re navigating the intricacies of financing an acquisition under $10 million, this information is essential for your journey.

What is Seller Financing?

Embrace the power of seller financing – a strategic approach where you’ll receive an upfront down payment, followed by periodic, typically monthly, payments until the buyer fulfills the total payment.

For instance, let’s say your business is valued at $5,000,000, and you’re open to financing 50% of the purchase price. In this scenario, the buyer initiates the transaction with a $2,500,000 down payment and proceeds to make monthly payments until the seller note is completely settled.

When preparing to market your business, it’s pivotal to make an early decision on whether seller financing will be on the table. This decision holds significant weight as it directly influences how the buyer plans to fund the acquisition. Often, one of the initial inquiries from potential buyers pertains to your willingness to finance a portion of the sale.

Given that the seller effectively assumes the role of a financial institution, it’s customary for sellers to prequalify buyers before committing to financing. This prequalification process may encompass a thorough evaluation, including a review of the buyer’s credit report, an assessment of their prior business experience via a detailed resume, and, in certain cases, even enlisting the services of a private investigator. Buyers may also offer their personal assets as collateral, alongside the business assets.

Typically, most small business sellers seek a minimum down payment of 50%, and the terms of seller financing generally span from three to seven years. However, it’s imperative that these terms align financially for the mutual benefit of both parties involved.

In the middle-market business landscape, it’s common to encounter deal structures featuring a seller note, typically ranging from 10% to 30% of the total purchase price.

Additionally, sellers often assert the following requirements:

  • Buyer Compliance: Sellers may stipulate that buyers must meet specific criteria or financial milestones post-closure, such as maintaining a designated level of working capital or inventory.
  • Ongoing Financial Insights: Sellers might request access to financial statements throughout the loan’s term, ensuring transparency and a clear view of the business’s fiscal health.
  • Lease Continuity: In many cases, sellers opt to remain on the lease for the duration of the note, providing stability and continuity in the business premises.

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

  • Delayed Taxes: Sellers only pay taxes once they’ve received the money. Ensure the note is “non-negotiable.”
  • Enhanced Selling Price: Businesses with seller financing typically command a 20% to 30% higher selling price compared to all-cash deals.
  • Expedited Sales: Businesses offered with seller financing tend to sell more quickly and effortlessly than those offered solely for cash.

What is an Amortization Period?

When it comes to buying or selling a business, amortization simplifies the process of repaying debt through fixed, scheduled installments. In essence, it’s the method of gradually paying off a loan over time.

Consider this scenario: You acquire a business for $10,000,000, making a down payment of $7,000,000. To cover the remaining $3,000,000, you secure a loan with monthly repayments that include both interest and a set portion of the principal.

If you’re evenly distributing these payments over the loan’s lifespan, you’re effectively amortizing your debt.

Initially, a significant portion of your monthly payment primarily covers interest, with the remainder allocated to the principal.

As time progresses and you advance in repaying the debt, a larger share of that monthly payment starts chipping away at the principal. In our ten-year amortization example, your monthly payments for the $3,000,000 loan would amount to roughly $33,000. Initially, most of this sum serves interest, but as you approach the end of the amortization period, the bulk of the $33,000 contributes to paying off the principal, ensuring the debt is retired as planned within the ten-year timeframe.

How Can I Protect Myself from the Buyer Not Paying?

When you’re extending financing for a portion of the sale, it’s crucial to adopt a prudent approach akin to that of a financial institution. Qualifying the buyer before making a commitment is essential. We strongly recommend initiating the process by gathering comprehensive information from the buyer, including a detailed financial statement, credit report, resume, and any other relevant data.

Furthermore, it’s wise to choose a buyer who not only meets financial criteria but also demonstrates the operational capability to succeed in your business.

If your potential buyer is a company, inquire about their track record with previous acquisitions. Engaging in conversations with owners of companies they’ve previously acquired can provide valuable insights. Depending on the company’s size, conducting due diligence on the acquiring company’s principals may also be a prudent step.

It’s worth noting that many issues related to seller financing stem from accepting a low down payment. To mitigate this, we strongly advise requesting a substantial down payment, ideally ranging from 30% to 50% of the asking price. This approach minimizes the likelihood of buyers walking away from a deal with such a significant upfront commitment.

Are There Any Other Ways I Can Protect Myself?

Crafting a robust promissory note necessitates the inclusion of clauses explicitly addressing non-payment and late payments.

To bolster your position, consider filing a Uniform Commercial Code (UCC) lien against the business. This strategic move prevents the buyer from selling the business or its assets during the note’s term.

In cases where the buyer is an individual, there may be room for negotiations to collateralize the buyer’s personal assets, alongside those of the business. However, exercise caution as this can sometimes convey a lack of faith in your business. Typically, we handle the drafting of these documents during a closing, but it’s worth noting that an experienced escrow agent or attorney can also perform this task competently.

Furthermore, you have the option to stipulate that the buyer must uphold specific financial benchmarks post-closing, such as maintaining a minimum inventory level, ensuring adequate working capital, or adhering to specific debt-to-equity ratios. To maintain oversight and proactively address any issues, we strongly recommend securing access to monthly or quarterly financial statements. This practice enables you to identify and rectify potential problems in a timely manner.

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

Since the seller plays a pivotal role in financing a portion of the sale, it’s imperative to approach the transaction with a mindset akin to that of a bank. If you’re the buyer, we strongly advise promptly furnishing the seller with essential documents. These should include comprehensive financial statements, your credit report, a detailed resume, and any other relevant information pertaining to your financial background.

In cases where you represent a company, it’s advantageous to compile a record of your past acquisitions. Facilitating conversations between the seller and owners of companies you’ve previously acquired can offer valuable insights and strengthen your position.

What Interest Rate is Fair to Charge?

Over the past decade, interest rates for promissory notes have typically fluctuated between 6% and 8%. The specific rate is contingent upon the level of risk associated with the transaction, with less emphasis placed on prevailing market interest rates.

Occasionally, buyers may argue that the interest rates for residential real estate mortgages are significantly lower and should be competitive. It’s important to clarify to buyers that such comparisons may not be apt. Financing the purchase of a small business carries unique risks, with limited collateral available, often restricted to the business’s undervalued assets. In contrast, defaulting on a residential mortgage allows the bank to reclaim the property. In the realm of small business acquisitions, there’s often little to recover in the event of a default, except a struggling business.

Several factors influence the determination of the interest rate, including the total business price, the buyer’s creditworthiness, their experience, financial standing, and, notably, the amount of the down payment. It’s crucial to understand that the interest rate primarily reflects the level of risk inherent in the transaction, rather than mirroring prevailing market interest rates.

How Do I Know How Much to Finance?

When deciding the extent of financing, it’s imperative to align it with your cash-flow dynamics. If your business consistently generates a monthly profit of $100,000, opting for a $90,000 monthly note would logically make sense. Not only should the profit comfortably cover the note amount, but it should also provide you with the means to pay yourself a reasonable wage. If this financial equation doesn’t add up, it’s simply not a feasible option.

Drawing from insights gleaned from over 10,000 business sales, here are the key statistics:

  • Average Interest Rate: Typically falls within the range of 6% to 8%, though there can be slight variations. This rate isn’t influenced by prevailing market interest rates but is primarily determined by the level of risk associated with financing a business. Given the inherent risks, these rates are relatively higher compared to other asset classes.
  • Average Note Duration: Averaging around five years, note lengths can vary between three to seven years, depending on the specifics of the transaction.
  • Average Down Payment: While a 50% down payment is customary, it’s essential to note that it can range from 30% to as high as 80%, depending on the particulars of the deal.
  • All-Cash Transactions: Interestingly, less than 10% of business sales are completed as all-cash deals, highlighting the prevalence of seller financing as a common practice.

Why Should I Use a Third-Party Loan Processor?

Opting for a third-party loan servicing provider is a prudent choice. These professionals adeptly manage every facet of the loan process, from collection to crediting and disbursing monthly payments. As a neutral intermediary, they streamline the entire loan management process, making it effortless for all parties involved. Entrusting payment administration to a third party also simplifies your recordkeeping, ensuring a smooth and efficient financial transaction.

Should the Seller Remain on the Lease?

As the seller, it’s crucial to secure your position by maintaining control of the lease throughout the entire note period. This safeguards your ability to reclaim the business and repossess the lease in the unfortunate event of a buyer default.

Alternatively, you can negotiate a clause that grants you the option to reclaim the lease if the buyer defaults, even if you’re not actively on the lease during the transaction. However, navigating this aspect requires the expertise of an experienced broker or real estate attorney to ensure all parties’ interests are properly protected.

Can I Sell the Note if I Need Cash?

Typically, you have the option to sell the note once it has matured, a process that typically takes six to 12 months. Several investors specialize in purchasing such notes, providing you with a means to cash out.

It’s important to note that selling the note often comes at a considerable discount. However, in many cases, this remains one of the primary alternatives for note holders. To keep this option available, it’s crucial to ensure that the note is structured to permit transfer or assignment to a third party.

Should I Hire a Private Investigator?

If you’re contemplating financing a substantial portion of the purchase price and have reservations about the buyer’s credibility, taking measures to protect yourself is a prudent step. Investing in an investigation at this stage can potentially save you a significant sum in the future, particularly if it unveils red flags regarding the buyer’s creditworthiness.

Engaging a private investigator offers valuable insights into the individuals interested in acquiring your business, including any undisclosed information such as aliases and addresses. This data can be instrumental in assessing the buyer’s character and financial trustworthiness.

Moreover, a skilled investigator can uncover pertinent details about the potential buyer’s legal history, outstanding debts, or past litigation. Such information can serve as a predictive indicator of their likelihood to default on the loan you’re considering. By delving into public records, an investigator may uncover undisclosed arrest records, bankruptcies, corporate filings, court records, criminal history, property deeds, or divorce filings.

It’s essential to be aware that obtaining this information may require a legally mandated signed release. While buyers have the right to refuse such a release, it’s important to convey to them the necessity of this action, given the financial risk you’re assuming. Clarify that this is a standard procedure, even with banks or financial institutions. For specific guidance, it’s advisable to consult with your attorney to navigate this process effectively.

What Documents Need to be Drafted?

To facilitate a seller note, you’ll require two essential documents: a promissory note and a security agreement. Additionally, it’s crucial to file a Uniform Commercial Code (UCC) lien on the business’s assets following the completion of the sale.

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

When marketing your small business for sale, it’s a strategic move to provide clear and specific terms. This conveys a strong message to potential buyers that you’ve meticulously evaluated the sale and approach it with a serious and practical mindset. Prepared sellers tend to attract more interest, and offering some form of financing rather than an all-cash deal often generates a higher response rate.

In the realm of mid-sized businesses, a different approach prevails. It’s customary to market these businesses without specifying a price or offering specific terms upfront.

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

In such instances, our recommendation is to include in your ad copy that financing is open to negotiation. You need not outline precise terms for financing in this stage. This approach does not bind you to providing financing but ensures that your listing remains attractive to potential buyers who specifically seek businesses with seller financing options.

How Many Years Should the Note be For?

Typically, notes span a duration of three to five years, a guideline based on practicality. It’s essential to ensure that the business’s cash flow adequately covers the debt service. Let’s examine a straightforward scenario:

Won’t work — debt service too high

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

Clearly, the scenario where the payment constitutes 94% of the annual business profit is unfeasible. A more pragmatic approach would involve a four- to five-year term. It’s worth noting that the term’s length has a more substantial impact than the interest rate itself.

Ideally, the payment should amount to less than one-third of the business’s annual cash flow. If the business maintains consistent cash flow year after year, you can consider a slightly higher payment. However, if cash flow exhibits fluctuations, it’s advisable to introduce a buffer and structure the note to ensure a lower payment.

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

The seller note can be directed to another entity, such as a creditor of the seller. This arrangement is permissible as long as the contract stipulates that payment to the entity is considered equivalent to 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 is acceptable, provided that the contract explicitly states that paying the individual owner is synonymous with paying the seller.

Conclusion

For small businesses: If you’re hesitant to finance the sale of your business, it’s important to recognize that there’s likely another seller with a competitively priced business similar to yours who is willing to offer financing. Serious sellers should seriously consider financing the sale, particularly if the business isn’t pre-approved for traditional bank financing.

For mid-sized businesses: It’s worth noting that the majority of middle-market M&A transactions incorporate some degree of seller financing, albeit typically at modest levels, often ranging from 10% to 20% of the total transaction size.

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