What is Seller Financing? How Does it Work?

Summary: Seller financing is a common financing component of many business acquisitions. It's a type of loan that the seller of a business offers to the buyer. The loans are privately negotiated between the participants and usually have competitive terms and rates. In this article, we discuss:

  1. What is seller financing?
  2. Advantages to the buyer
  3. Advantages to the seller
  4. Disadvantages to the seller
  5. Seller financing structure
  6. Transactions with seller and lender financing
  7. Conclusion

1. What is seller financing?

Few buyers can acquire a business without using any financing. They often rely on lenders to finance a large portion of the purchase. The loans are usually provided by finance companies, banks, family offices, institutional investors, and private equity (PE) firms.

However, these are not the only sources of financing. Some transactions have a component that is financed by the seller. Sellers play a role in funding a large percentage of acquisitions. Most sellers finance only a small portion of the acquisition. Lenders usually provide most of the financing. In some cases, sellers finance the whole transaction, though this is rare.

Seller financing packages are usually structured as term loans. There is no universal way to structure a transaction. The details of the loan are negotiated between the buyer and seller. Usually, seller financing loans have competitive terms and rates.

2. Advantages to the buyer

Buyers prefer transactions with a seller financing component, even if it's a small one. Buyers like seller financing because if offers several advantages for them.

a) Increases sales transparency

The most important advantage of this option is that it ties the seller to the business for the loan duration. This term can be as long as seven years. Keeping the seller tied to the company can prevent sellers from exaggerating the business's performance. After all, the seller is not walking away from the business after the sale. The seller will be in contact with the buyer to collect a payment for a number of years.

b) Helps enforces seller's post-sale commitments

A seller-financing component provides a tool to help ensure the seller fulfills their post-sale commitments. Consider the following example. Assume you buy a business without seller financing. As part of the sale, the seller enters into a 6-month consulting agreement to help you with the transition. This essential component of many acquisitions provides a smooth ownership transition.

Shortly after closing the sale, the seller changes their mind about the consulting agreement. They decide they won't provide the transition consulting after all. Instead, they will retire and move out of state.

This situation leaves you exposed at a critical juncture of the transition. The seller's consulting services are important to the success of your acquisition. However, you would have limited options to compel the seller to provide. You could try using legal action, but it would be expensive, time-consuming, and won't provide an immediate solution.

A well-crafted seller financing component can offer some leverage in this situation. The seller still has a portion of the sale price tied to your financing agreement. They have an incentive to perform well to ensure continued payments.

c) Easier to get

Seller financing can be easier to get than conventional financing. Sellers are less sophisticated than banks and don't usually have complex underwriting requirements. Furthermore, many sellers offer competitive rates, though not as low as lender rates.

d) More flexible

Sellers have a vested interest in selling their business and may be willing to offer unconventional financing options. These financing options can include an unusual structure, amortization, term, or collateral features.

e) Alternative option

Some transactions cannot be financed with lender financing due to issues with the transaction (e.g., size or industry) or the buyer. Seller financing provides an alternative option that allows buyers and sellers to execute the transaction.

3. Advantages to the seller

Although sellers prefer to get paid immediately, there are advantages to providing financing in some transactions. These advantages need to be carefully evaluated.

a) Shows confidence

One of the more important benefits of providing financing to buyers is that it shows that the seller is confident in the business. After all, part of the seller's compensation remains tied to the business. Consequently, buyer confidence in the company also increases.

b) Increases marketability

Selling a company is difficult and time-consuming.  Furthermore, some transactions have substantial competition among sellers. Offering seller financing can make a business stand out in a crowded market and attract buyers.

c) Backup option

Conventional lenders are not able or willing to finance every transaction. However, most buyers require some level of financing to buy a business. In these cases, seller financing provides a way to bridge that gap.

d) Potential gains

Some experts advocate that offering to finance buyers can provide additional gains to the seller. These gains come from the buyer's interest payments on the loan. While this gain is technically possible, we have not seen substantial interest in this advantage from sellers. In our experience, sellers dislike becoming lenders and prefer an immediate payment when possible.

e) Potential for higher price

Offering seller financing may allow a seller to sell for a higher price. This scenario may be challenging in transactions that also have conventional lender financing. Consequently, the strategy may have some benefits, but the benefits are somewhat limited.

Consider a transaction in which a business sells for a higher-than-appraisal price and where the price difference is covered through seller financing. This transaction leaves the business with a high debt level. Many lenders require businesses to pay all their loans from the company's proceeds. If the business cannot do this, the senior lender will participate only if other loans (e.g., seller financing) agree to take a "standby" position. A standby position prevents the seller-financed loan from getting paid until the senior lender is paid off. While this situation allows for a higher price, it would also delay payment substantially.

4. Disadvantages to the seller

In our experience, sellers offer financing only when they have no other choice. Most sellers prefer immediate payment. This is because seller financing has important disadvantages.

a) Delays payments

The most important disadvantage to the seller is that offering financing delays their payments for the sale. Furthermore, transactions with senior-lender external financing may require the seller financing loan to have a "standby clause." As previously explained, this clause can prevent the seller from getting paid until the senior lender is paid off.

b) Turns the seller into a lender

Providing seller financing turns the seller into a lender. Consequently, the seller needs to spend resources to evaluate a buyer's creditworthiness. This process adds to their risk. Sellers must also retain an attorney to structure a note and ensure it complies with all relevant laws.

c) Minimal collateral

Senior lenders (e.g., SBA-backed lenders) take the first position in all the company's and buyer's collateral. If the seller is a junior lender, they will have to take a subordinate position to the senior lenders. The subordinate position substantially reduces the seller's chances of getting paid in the event of default.

d) The company could fail

The buyer's loan payments will be made from the company's proceeds. However, collecting from the buyer will be difficult if the company fails. This situation exposes the seller to additional risks beyond their control.

5. How is seller financing structured?

The structure of the seller financing package depends on the number of participating lenders. The structure is flexible if the transaction has no senior lenders. The seller and buyer can agree to any financing package that complies with the law. However, having a senior lender can influence the seller financing package structure. For example, transactions financed with SBA-backed loans require the seller financing package to meet certain criteria.

In our experience, seller financing packages usually have:

  • 3- to 7-year terms
  • 5% to 10% APR

Additionally, many seller financing packages have a balloon payment at the end but are amortized over a longer period of time.

Seller financing loans used in combination with other loans, such as SBA-backed loans, don't have a down payment. Transactions in which the seller is the only lender usually have a down payment. Transactions with 100% seller financing are very uncommon.

6. Seller financing role in SBA-backed transactions

Seller financing plays a significant role in financing small business acquisitions. Many acquisitions that use an SBA-backed lender also use seller financing. For the most part, the SBA does not affect the seller financing component other than requiring that it be reasonable.

However, there is an exception. SBA loans require that buyers put 10% equity into a transaction. This contribution is called an equity injection. There are transactions in which the equity injection is split between the buyer and the seller. However, such transactions have these restrictions:

  • The buyer must contribute at least a 5% equity injection
  • The seller must finance at least 5% of the transaction
  • The seller must take a standby on the loan

7. Conclusion

Sellers should offer financing only after weighing the risks and benefits carefully. They should retain an experienced attorney to help them craft the lending documents. This step helps ensure they understand their responsibilities, protections, and risks. An attorney also ensures that the loan complies with the appropriate regulations.

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Editor's note:

This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.

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