Seller financing in business acquisitions

When it comes to buying a business, it is pretty rare for an acquisition entrepreneur to buy out an owner in all cash. Instead, searchers often turn to various forms of debt to help them buy a small business.

Debt is helpful for a few reasons. First, it increases your buying power. If you can get a loan for 80% of the purchase price, you can buy a business 5x bigger than what you can buy with cash only. Second, it helps improve your returns. By adding debt to your acquisition, you can get a better return on your invested capital. 

Seller financing is a form of debt between the buyer of a business and the seller of the business. In addition to increasing a buyer’s buying power and improving their returns, seller financing is unique in that it offers a third benefit. It helps align incentives between buyers and sellers in business sales.

If a seller has skin in the game in the form of a promissory note for some portion of the purchase price, the logic is that they will be more invested in helping transition you into the owner seat. In fact, some SBA lenders explicitly require acquisition entrepreneurs to include a seller note in their acquisitions for this very reason.

When does seller financing come into play?

Generally speaking, there are two approaches to using seller financing. 

For some deals, seller financing may be the only form of debt in the acquisition. This may be due to the business target failing to qualify for an SBA loan (e.g., it’s in a vice industry, it has too much customer concentration, or it hasn’t been in business long enough for a lender to feel comfortable making a larger term loan). Other times, acquisition entrepreneurs are wary of providing a personal guarantee and adding a lien to their home for an SBA loan and only look for deals that can be done with seller financing and a down payment.

For other deals, seller financing may be a minority of the total sources for an acquisition. This is quite common in SBA-backed acquisitions, where the seller will hold a promissory note for 5-15% of the purchase price of the business. Many business brokers have conditioned business owners to expect to seller finance around 10% of the asking price.

Most listings and CIMs produced by business brokers will state upfront whether seller financing is on the table and, if so, how much the seller is willing to extend.

What are the typical terms of seller financing in a business acquisition?

• Term - The term is the duration of the promissory note, which is the legal document that outlines the seller financing. At the end of the term, the entire note should be paid off.

• Rate - This is the interest rate being charged to the borrower.

• Amortization Profile - This is the mechanism for calculating how much is owed each period. Typically, this is a straight amortization profile, meaning equal payments throughout the term of the loan each period until the note is fully paid off. Sometimes, there may be a 10-year amortization with a 5-year balloon, meaning that there are payments as if being paid off over 10-years but the balance is due at the 5 year mark.

• Contingency - Some notes are structured to have contingencies. For instance, perhaps the seller note will be forgiven if the revenue drops or a key customer cancels a contract. The purpose of contingencies is to tie the payment of the note to the success of the transition and new owner of the business. Seller notes with such contingencies are typically referred to as "forgivable."

• Subordination - If there is a bank loan involved in financing the acquisition, the seller note will often be subordinated. This means that if the borrow goes into default, the bank will get paid its outstanding balance before the seller. For SBA loans, this is non-negotiable.

• Security - A seller note can be secured by the assets of the acquired business or by the buyer, personally. For large seller notes, some may only be secured by interests in the company, meaning the prior business owner can take over the business again if the borrower goes into default.

Comparing terms of seller financing

The market terms for a seller note vary based on whether the transaction is a majority seller financed deal or minority seller financed deal (e.g., most of the sale price is paid through a bank loan).

SBA loans and seller financing

When using seller financing with an SBA loan, acquisition entrepreneurs will often be surprised by the seller note’s impact on cash flow. Generally speaking, seller financing hurts the debt-service coverage ratio of a deal. Why? Well, even if the rates are lower, the term is so much shorter that it typically offsets any benefits of a lower rate. 

Said another way, if you needed to borrow another $100K for a deal, you’re better off increasing the size of your SBA loan than turning to seller financing, if your only goal is to maximize DSCR and returns.

Typically, the reason searchers turn to seller financing is for incentive alignment and encouragement from SBA lenders, not for its below market rates.

When using seller financing with an SBA loan, it’s important to be aware of the SBA’s standby creditor agreement. Any owner issuing a promissory note to the buyer of his business will be required to sign this document. If it’s any reassurance, you can remind the owner that any landlord will need to be similarly subordinated.

Comparing Seller Financing to SBA Loans

With larger businesses, it’s quite rare for a business owner to being open to seller financing more than 15% of the purchase price. Because of this, seller financing is often a complement to SBA financing and not a replacement.

However, some owners express interest in seller financing due to its tax benefits. When this is the case, these business owners are often much more active in vetting and interviewing buyers, as their proceeds are very much tied to the buyer’s repayment ability. If a buyer defaults and runs the business into the ground in the process, the owner may be left with no business and not much money to show for it.

Here are some of the big comparison points between SBA and seller financing:

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.