The decision to sell your small business can be one of the most difficult choices you’ll ever make. Still, leaving your business is inevitable, and every business owner needs an exit plan. Unfortunately, there’s no guarantee you’ll find a buyer with a ready supply of cash. As a result, many small business owners offer seller financing to increase the likelihood of a successful sale. Though seller financing has its advantages, there are potential risks involved. Understanding the pros and cons of seller financing your small business sale can help you determine if it’s the right exit path for you.
What is Seller Financing?
In a traditional business sale, buyers must come up with their own funding. Often, buyers use a combination of cash and third-party financing to cover the purchase price. Seller financing, also called owner financing or seller carryback, removes the middleman—typically a bank or other lender. Instead, the seller and buyer come up with their own funding deal.
Typically, the seller offers a loan to the buyer that covers a portion of the sale price. The buyer then makes an upfront payment in cash and repays the seller-financed portion in installments, with interest.
Since seller financing can be mutually beneficial for buyer and seller, it’s used frequently by exiting business owners. In fact, 60-90% of small business purchases involve seller financing, according to Guidant Financial.
The Benefits of Seller Financing Your Small Business Sale
Benefit #1: Seller Financing Your Small Business Sale Can Boost Your Overall Payout
According to BizBuySell, partially financed sales typically result in a sale price that is more than 15% higher than their cash sale counterparts. In addition, repayment terms are usually between five and seven years with an interest rate in the 6-10% range. If the buyer is a good credit risk, you stand to earn a higher rate of return on your loan than you’d otherwise earn in the market.
Furthermore, seller financing your small business sale can help you avoid an immediate tax burden. Since the buyer typically pays you back in installments rather than one lump sum, you can spread the tax liability over several years.
Benefit #2: Expands the Pool of Potential Buyers
Only 48% of small businesses have their financing needs met, according to the Federal Reserve’s 2019 Small Business Credit Survey. Moreover, 9% of small businesses receive no capital after applying for a loan. Offering to seller finance the sale of your small business can attract potential buyers who otherwise would not qualify for adequate financing.
Benefit #3: Indicates the Owner’s Confidence in the Business
When a small business owner is willing to partially finance the sale of their business, it’s often a sign that they’re confident the business will generate enough profit that the buyer can comfortably pay back the loan. Similarly, an unwillingness to seller finance the sale of your small business can signal that the business is in trouble. This is one of the reasons seller-financed business sales tend to result in a higher sale price.
Benefit #4: Allows the Deal to Close Faster
Securing a bank loan can take up to six months, depending on the bank’s approval process. However, not all business owners can or want to wait this long to sell and exit their business. For motivated sellers, financing part of the transaction can help close the deal faster.
The Risks of Seller Financing Your Small Business Sale
Risk #1: Ties You to the Ongoing Performance of the Business
When you sell your business outright, you can walk away from your business completely. However, seller financing your small business sale means you’re tied into the business for the duration of the loan. Assuming the business succeeds, and the buyer pays you back according to your terms, this may not be an issue.
On the other hand, if the business struggles, you may be called back to turn things around or repossess the business. In addition to losing interest income, your business may be worth considerably less when you repossess it. Plus, you’re likely to incur additional costs during the process.
Risk #2: Assumes Credit Risk of Buyer
As a lender, it’s your responsibility to evaluate the credit worthiness of your borrower. Failing to do proper due diligence can result in loss of interest income, not to mention time and energy devoted to the collection process.
Fortunately, there are steps you can take to reduce your risk. For example, in most cases it doesn’t make sense to finance more than 30-60% of the sale price. An exception to this guideline may be if you’re transferring your business to a family member or close insider, and you’re willing to accept additional risk.
In addition, you can minimize your risk by requiring a substantial down payment in cash. Many business owners also file a blanket or UCC-1 lien, which gives you a legal claim to all of the borrower’s business assets if they default on the loan. Similarly, you can require the buyer to put up collateral and/or sign a personal guarantee.
Risk #3: Gives You Less Capital Up Front
We all know the proverb, “a bird in the hand is worth two in the bush.” In other words, having cash in the bank today is better than risking everything by seeking a higher future payout.
Although seller financing your small business sale often results in a higher overall payout, you receive less cash on the front end. If you tend to be more risk averse, making this tradeoff may not be the right choice when it comes to selling your business.
Risk #4: Seller Financing Your Small Business Sale Can Be Complex
One of the benefits of seller financing is that it avoids the red tape of working with a third party. However, trying to do everything yourself can be risky if you don’t understand the complexities of structuring a loan agreement. It’s usually advantageous to seek the advice of trusted legal and financial experts before committing to a deal.
Bottom Line: Do Your Due Diligence Before Committing to a Seller Financing Deal
Buyers often push for seller financing, especially those who can’t secure financing elsewhere. Nevertheless, it’s important to do your homework and consider all options before caving to this type of pressure. No matter how motivated you are to sell your business, rushing into a seller financing deal can seriously impact your ability to retire on your own terms.
Oak Capital Advisors specializes in exit and retirement planning for small business owners. If we can help you determine if seller financing your small business sale is a viable exit path for you, we would be happy to hear from you. Please get started by requesting your complimentary retirement readiness assessment.