Seller financing is when a business’s original owner offers the buyer a loan to cover a portion of the price of the business. First, the buyer makes a down payment in cash as soon as the deal closes. The seller’s loan covers the remaining amount of the sale price, plus interest, according to the terms set by the lender. This rarely covers the entire price of a business, so buyers usually use another form of financing in tandem with their seller’s loan.
Some aspiring small business owners don’t necessarily seek to start their own ventures, but to revamp, modernize, and customize existing businesses. Of course, buying a business requires money, but small business loans for business acquisition, like SBA 7(a) loans, can be hard to qualify for. And if you’re trying to sell your business, you might struggle finding buyers that have the cash to buy you out as quickly as you’d like. So, for both sellers and your prospective buyers, seller financing can be a lifesaver.
Here, we’ll tell you more about seller financing—also known as owner financing in terms of real estate deals—why you should consider it, and how to tell if it’s the best way to let go of your business.
As we mentioned, seller or owner financing is when a business owner—the seller—offers the buyer a loan to cover a portion of the cost. First, the buyer makes a down payment in cash, typically in the amount of one-third of the sale price, as soon as the deal is closed. The seller’s loan covers the remaining amount of the sale price, which the buyer repays in regular installments, plus interest, according to the terms set by the lender. This type of financing rarely covers the entire price of a business, so buyers usually use another form of financing in tandem with their seller’s loan.
If you’re looking to help ease the process of selling your business, you’ll need to know: How does owner financing work?
Once you choose to sell your business with seller or owner financing, your buyer will pay for a portion of the business upfront in cash. You’ll finance the rest of the sale in the form of a loan. Your lawyer will draw up and file the terms of your loan in a promissory note, which is essentially a legally binding IOU.
Usually, repayment terms for a seller financing loan are similar to those of a business bank loan, with repayment lengths somewhere between three and seven years, monthly repayments, and low interest rates (think 6% to 10%).
If you decide to offer this type of financing to sell your business, it’s crucial that you require your buyer to put up collateral. In this instance, you are in the same position as a bank or alternative lender would be in a traditional loan scenario. That means you have the freedom to determine the terms of your loan (with the help of your business broker, financial advisor, and/or your lawyer), but that also means you’re taking on the risk that your buyer will default on their payments—and that you’ll end up losing all that capital.
Just like in any other small business loan, securing your deal with some type of collateral mitigates the risk inherent to the loan.
Your buyer’s down payment is your first line of defense. If your borrower falls behind on their payments, or neglects them completely, you’ll still have that cash safely in hand. Then, the business itself acts as collateral: If your borrower defaults, you can reclaim the business and its assets, as well as control over its operations.
Often, though, sellers require additional collateral, usually in the form of a personal guarantee. That personal guarantee allows the lender (in this case, the seller) to seize and liquidate the borrower’s personal assets in case they fail to repay their debt. But you can also require specific forms of collateral to secure your loan, like homes or other personally owned real estate. Again, the exact terms of your seller financing deal are up to you, your buyer, and your business lawyer or financial advisor.
As the owner of your business, deciding how to sell your business is a big decision, and it’s important to decide whether the benefits outweigh the drawbacks. Here are a few of the major pros and cons of offering seller financing:
The first major benefit of offering seller financing is that it makes the terms of your deal much more attractive to prospective buyers. Most buyers don’t have the cash on hand required to purchase a business outright, but some banks and alternative lenders are wary about loaning money for the purpose of business acquisition. And in general, securing a bank loan is notoriously tough for most borrowers, since banks only want to work with the most qualified borrowers before risking such large loan amounts.
Most business owners—or, in this case, aspiring business owners—don’t have all the necessary qualifications to secure loans from traditional lending institutions, so prospective buyers turn toward seller financing as an alternative financing route.
For that reason, as a seller you’ll have a lot of buyers knocking on your door if you offer this type of financing. Also, the sales process can be faster if you offer owner financing, as you’re not dealing with the intermediary of a bank or other lender.
According to Joshua Escalante Troesh, a financial planner and president of Purposeful Strategic Partners, seller financing can actually be lucrative in the long run. Escalante Troesh says:
Compared to receiving a lump-sum payment for a business seller financing can be an incredibly valuable financial planning tool. If the deal is structured correctly, it can provide a higher return through the [promissory] note’s interest rate, which also provides the former business owner with a steady stream of cash flow.
Another major benefit is that, generally, sellers can get the asking price for their business if they offer financing in the sale’s terms. Once you know how to value your small business, you and your financial advisor or business broker can set the asking price that’s most beneficial for you.
Probably the biggest turn-off for business owners considering seller financing is the risk involved in personally financing a loan. (But that’s what collateral safeguards against!)
Also, it requires the original owner to retain a vested interest in the business until the buyer to satisfies the loan agreement and the sale is complete. If you’re looking for a clean break from your business, and you have no desire to maintain some level of involvement in its success, owner financing might end up becoming burdensome.
If you’re considering seller financing for your business, you might be nervous about the prospect of lending a big chunk of cash to someone you don’t know personally. Lending this amount of money to someone who’s not your family or friend is likely new territory for you, and that leap requires some trust.
More than trust, though, lending requires a strict vetting process. Just like any other bank or lender who offers loans to buy a business, when you assess incoming offers you’ll need to ensure that your borrower is reliable enough to run your business successfully and pay back their loan.
In particular, pay attention to the following qualifications when sifting through buyer applications:
You’d want your business’s new owner to be the most qualified person possible for the job—even if you weren’t fronting them the cash to buy it. But because you are throwing your own skin into the game with an owner financing deal, you need to be extra confident that the new buyer can turn a profit off your business.
Potential buyers with experience in your particular industry are your safest bet, since they’re the most informed on the landscape of your business—how to weather the storms, and how to maximize the windfalls.
In their application, you should ask your potential borrowers to provide a short cover letter explaining why they’re eligible for your loan (and to take over your company). If there’s any indication that a potential buyer doesn’t have the experience to successfully run your business, think very carefully before offering seller financing, let alone letting them take over the reins of your business. After all, the fulfillment of their loan is contingent upon their ability to turn a profit within your industry.
On a related note, your new buyer must come to the table with an airtight business plan in hand. This strategic road map details the new owner’s vision for the business, and exactly how they’ll achieve that goal; it’s the foundation of a successful business.
Keep in mind that business plans are living documents, and owners can make changes to business plans if they find that their original strategy isn’t working. But you know better than anyone what will and won’t work for your business and in your industry.
If a potential buyer comes in with a shaky business plan, or it plans for unrealistic financial goals, that may be an indication that this buyer isn’t the most qualified to run your business. In turn, that indicates a higher risk of defaulting on their loan.
In addition to their business acumen, you’ll also want to get a sense of a potential buyer’s financial track record. Obviously, you’re not only letting go of your business in a seller financing deal; you’re also assuming that the new owner is reliable enough to satisfy the debt they owe you.
Take your cue from pretty much every business lender out there and request to see your borrower’s personal credit score. Lenders (that means you!) almost always require a minimum personal credit score, because those scores are a good measure of an individual’s financial responsibility—namely, their ability repay their debts in full and on time.
The higher the better in a potential borrower’s credit score, but in general you’ll want to look for borrowers with scores above 650. If they’re a business owner, you’ll want to check up on their business credit score, too.
As you now know, collateral is crucial in securing a seller financing deal. Right off the bat, you should have your borrower make a down payment soon after the deal is closed. Collateral can also take the form of a blanket lien on the business’s assets, and a personal guarantee that covers the borrower’s own assets; all are standard operating procedure in a seller financing deal.
If a prospective buyer you’re considering shies away that collateral, or refuses the down payment, they’re likely not serious enough to take on the task of running your business and repaying their loan. In that case, move onto the next applicant.
What does owner financing mean for you as the seller? The truth is, offering seller financing makes your business much more attractive to prospective buyers, since it eases their financial burden upfront. In fact, some buyers won’t even consider purchasing a business from an owner who doesn’t offer to finance part of the sale, because that may indicate that the seller doesn’t believe in the future of their business. (If a seller were confident that the business would remain profitable, then they’d be confident in a loan repayment dependent upon that profitability—right?)
That doesn’t mean you absolutely should offer owner financing when you sell your business, though, it isn’t out of the ordinary, but it certainly isn’t the only way a buyer could go. Selling your business is a major decision, and how you choose to do it is entirely up to you.
If you want to expedite the sale of your business, set the terms of your deal (along with your attorney), and don’t mind keeping your foot in the door of your business for a few years after closing, then you might want to consider offering seller financing to your prospective buyers.
On the other hand, you might not want to risk your borrower defaulting on your loan. You also may not want to keep the capital from your sale tied up in a loan, which will take your borrower several years to pay off.
As Escalante Troesh points out, though, “one of the most underrated benefits of receiving the sales proceeds over time is the psychological benefit. That adjustment period after the sale lets the former business owner figure out how to best manage the change to their financial situation.”
Overall, you’ll have to consider both the logistical and the emotional factors that come into play when you offer seller financing.
But although there is an element of independence in this, you should never go the seller financing route truly alone. Consult with a team of professionals, such as business brokers, accountants, financial advisors, and lawyers, who can walk you through the owner financing process and help you appraise incoming offers. Hire an attorney to draw up a contract that’s beneficial for you, protects your interests, and which sets forth terms that your buyer can truly meet.
Caroline Goldstein is a contributing writer for Fundera.
Caroline is a freelance writer and editor, specializing in small business and finance. She has covered topics such as lending, credit cards, marketing, and starting a business for Fundera. Her work has appeared in JPMorgan Chase, Prevention, Refinery29, Bustle, Men’s Health, and more.