As you work with your business broker to plan the details of a sale, it’s good to have an understanding of how seller financing works because that is part of a majority of business sales.
If you are really interested in selling your business, then it’s important to be mindful of the “competition” in the market for buyers. There are thousands of businesses for sale at any given time and many times a buyer looks at hundreds of businesses before finally choosing one. Though your business is unique, plan to have the terms of sale and seller financing be within the range of what a prospective buyer is seeing from other companies.
What is Seller Financing for Business?
Seller financing for a business is a financing arrangement where the seller of a business provides financing to the buyer instead of the buyer obtaining financing from a third-party lender such as a bank. In other words, the seller provides a loan to the buyer to help finance the purchase of the business.
In a seller financing arrangement, the buyer typically makes a down payment and then repays the seller over a set period of time, often with interest. The terms of the financing agreement, including the interest rate and repayment period, are negotiated between the buyer and the seller.
What are the Pros and Cons to Seller Financing?
Seller financing can be an attractive option for both buyers and sellers. For buyers, it can be easier to obtain financing from the seller than from a third-party lender, particularly if the buyer has a limited credit history or insufficient collateral to secure a loan. For sellers, offering financing can make the business more attractive to potential buyers, and can also provide a steady source of income from the loan payments.
However, seller financing can also come with risks for both parties. For buyers, the terms of the financing agreement may be less favorable than those offered by a traditional lender, and there may be a risk that the seller could foreclose on the business if the buyer fails to make payments. For sellers, there is a risk that the buyer may default on the loan, which could lead to a lengthy and expensive legal process to recover the funds. Therefore, it is important for both parties to carefully consider the terms of the financing agreement and seek professional advice before entering into such an arrangement.
5 Things to Consider With Seller Financing
Amount of Down Payment
It’s not uncommon for a buyer to get a business for about 20% down, so if you considering seller financing, you should be as conservative as possible in asking for a down payment. It is typical to get one times your yearly earnings or seller’s discretionary earnings (“SDE” on the low end) to 50% of the purchase price down (on the high).
SDE is equal to the amount of “benefit” that you receive from the business each year. This number is more than the profit on your tax return or profit and loss statement. SDE is the total amount of money that you make or your benefit as the owner. A quality business brokerage firm can help you discover this number.
A seller financed loan can have whatever interest rate the parties agree to, but remember that you are not a bank. This is an investment to you. Expect a much higher return on your money than you can get in most other investments, usually ranging from 2% above Wall Street Prime but no less than 6% and not more that 12%. (At the time of writing this book, prime is at 3.5%.) The bulk of the seller-financed businesses provide a return of 8% to 10%.
Some sellers, however, prefer to go with a more traditional bank approach and use a “variable interest” rate. For example, the interest rate could be Wall Street Prime + 2%, adjusted monthly, quarterly, or yearly based on the then current Wall Street Prime interest rate. Often there is also a floor and cap on the interest rate, such as not to go below 8% or over 12%.
Term of the Note
The term of the note is the length of time that a buyer has to pay the loan off, the period that the loan is “amortized.” There are several ways to determine the length of the term. A skilled business broker can walk through a process of analyzing the business current profit, the buyer’s living wage needs, rainy day fund, reasonable funds necessary to grow the business, and the amount reasonably available to service debt.
When selling a business, both the seller and the buyer want as much money as possible reinvested back into growing the company rather than taking the money out and weakening the company’s ability to pay. Therefore, the best way to have a “win/win” situation for the buyer and seller is to have a loan amortized for 10 years. While the loan is amortized over 10 years, we typically set a balloon payment at month 61. Sometimes, according to the quality of the business and the condition of the financials, we will do a balloon payment at month 37.
Therefore (as you may already foresee), the bulk of the payments you receive for the first three to five years are in INTEREST. When the buyer makes the balloon payment, be it at month 61 or 37, it is not far off of the total amount being financed.
Depending on the type of business, it may be necessary to offer a varied payment schedule to account for a variety of business-specific variables. For example, if you are in a seasonal business like a heating, ventilating, and air conditioning (HVAC) company, it might be logical to have the payments due in the summer be higher than the payments due in the winter. Not only will this seem more realistic for you, but also it is important for buyers to be mindful of the ebbs and flows of cash for their business.
Try to arrange the seller note to be paid in the way and at the times that you know the business can be better positioned to pay it. You may actually tell the buyer that they make no payments for three months, but then you would spread out over the rest of the year or maybe schedule it such that during the height of the business season (when the coffers are full), they are actually making double payments.
Also, consider allowing the buyer to get into the business and “get their feet wet” before making payments. I usually recommend 60 to 90 days before the first payment is due. This will help the buyer “settle in” and deal with those various additional expenses that always occur after purchasing a new company, and build goodwill in your relationship.
Seller Earn Out
An earn-out is a financial arrangement in which the buyer of a business agrees to pay the seller an additional amount of money based on the performance of the business after the sale. Specifically, the seller receives a portion of the purchase price at closing and the remaining amount is contingent on the future performance of the business.
A seller earn out can be used AS the seller-financed portion or in addition to the seller note. An earn out is typically used in situations where the value of the company is really in the “potential” of the company rather than based on the “past” earnings of the company.
So, for instance, if you have a business that has just signed a multimillion-dollar contract right before closing, this might be a solution for you. In a situation where there is a seller earn out, the business has to make the money BEFORE the buyer is obligated to pay the amount. This type of loan is not amortized until the “target gross revenues” are met. So in the situation where you have already signed a contract for the “extra” earnings, this makes sense.
Seller earn outs are also used when we are trying to bridge the (sometimes considerable) gap between what a seller wants for their business and what the business is actually worth. Therefore, the business is sold on the “potential” of the future rather than the past. There are times when a business has signed a large contract or there is some other situation that will cause the business to grow in the future without the involvement of the buyer. This means that IF the business does grow and accomplish what the seller claims that it will, then the seller gets an “earn-out” payment. Therefore, the sale price of the business is really based on the projections of the seller.
This is also used in situations when a business has had a downturn in profitability. In this scenario you, the seller, have the confidence that this is just a slight downturn due to external factors (or factors that you have taken care of). We put an earn out in place for the express purpose of getting the buyer to pay what the company was worth, all the while giving the buyer the confidence that the downturn was not long term and you are standing behind this claim.
Scot Cockroft is the Owner & President of the #1 ranked Business Brokerage, Business sales and M&A firm in Texas. Scot has been named Named Deal Maker of the Year by Dallas Business Journal.
He is committed to a “different” type of business brokerage firm, one that is NOT about a sales pitch but, rather, results! In short, a business brokerage firm that is committed to performance-based compensation. Scot believes in these principles as well as a candid honesty with clients. His candid style often takes buyers and sellers by surprise, but is often what assures successful connections between the two.
Feel free to reach out!