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This article is meant for business buyers. If you’re selling your business, read about seller financing from the seller perspective.
When buying a business, there are a variety of financing arrangements available to you. An SBA loan would likely be one of the first things that come to mind. Unfortunately, small business loans like the SBA 7(a) loan program can be difficult to qualify for and may not be enough to finance the whole purchase.
If your cash and other sources of loans aren’t enough to finance the acquisition of a business, seller notes or seller financing is another avenue to explore. It may be worth considering even if you have enough financing from other sources, because it puts skin-in-the-game for the outgoing owner(s).
How a Seller Note Works
A seller note is a form of debt financing structured as an interest-bearing loan. In this case, the seller pays a portion of the purchase price as a promissory note, which is effectively a binding IOU.
The note is a commitment that as the borrower, you will pay the amount owed through a series of debt payments. By allowing you to complete the purchase through deferred payments, the seller is effectively self-financing the transaction.
You make a down payment while the seller note covers the remainder of the sale price. The note includes the debt amount, term, interest rate and repayment schedule. Repayment lengths for seller financing typically range between three and seven years.
Seller notes can be the primary source of financing but are more often a means of completing the capital stack needed for the purchase. When they are the primary financing source, sellers will typically finance 30 to 60% of the purchase price. If you are looking to buy a business that lenders would ordinarily not be too keen to provide acquisition financing for, you may get seller financing closer to 60%. If you’re able to get additional financing from other sources, you should expect the seller to finance 5-15%.
At Beacon, we expect all of our business owners to be comfortable with seller financing 10% of the selling price or more.
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What is Required of the Business Buyer
Sellers do not all have the same mindset or risk appetite, so each one will define the actual requirements and terms of the note depending on what they expect to get out of the transaction. Just like a traditional lender, the seller may require specific information of you beforehand such as:
Down payment - You should be prepared to make a down payment of between 10% and 15% of the purchase price.
Credit report to establish that you have a good or excellent credit score.
Personal financial statement.
Resume showing professional qualifications and industry experience. If you’re not going to be the one running the business, the seller may want to see the resume of the CEO you plan to hire.
Business plan detailing your operations strategy and plans for running the business.
Collateral and personal guarantee - A seller note may be secured in times of high uncertainty or when the business cannot generate sufficient cash to pay off the debt. Collaterals that may be used to secure seller notes include company assets and personal guarantee. With a personal guarantee, your personal assets would be at risk if you are unable to keep up with payments.
Benefits of Seller Notes for Buyers
Seller is vested in business’ success - Since the seller remains vested until the seller note is paid in full, it is a sign that the seller has confidence in the future of the business. They also remain a go-to resource for guidance or advice when you need it.
Access to additional capital to bridge the price gap - The seller note can bridge the gap when you do not have sufficient funds to buy a business. If you can only qualify for a bank loan that’s 60% of the purchase price as well as equity that’s 10%, you may have seller financing for the remaining 30%.
Affordable payments - You make a single payment to the seller each month.
Quicker process - The transaction can be concluded more quickly at a price that is acceptable to the seller.
Increased flexibility - Increased flexibility in loan terms when compared to a bank loan.
Mitigate against challenging business circumstances and market environment - Sellers may arrange a seller note especially if the business has significant challenges. These challenges include irregular revenue patterns, cyclical nature, high capital intensity, growth capital needs, customer concentration and small size.
SBA loan capital contribution - SBA loans may allow the inclusion of the seller note when calculating your capital contribution to the transaction.
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Managing Risk in Seller Notes
The seller note will often contain multiple provisions to protect the seller. These risk management clauses may include:
The right to interest rate escalation if you default on payment terms.
Access to the business’ financial report to monitor its capacity to make future payments.
Converting debt to equity in the event of default.
Debt service coverage ratios not too different from those a traditional lender would impose. The seller may limit how much extra financing you can take on.
(Rarely) The seller may restrict how much you can spend. Your expenditure may be limited to no more than a specific percentage above the business’ largest expense period when the seller was still in charge.
(Rarely) For businesses whose success is dependent on the amount of inventory, the seller may insist that inventory remain at a certain level.
Some Important Points on Seller Notes Interest Rates
Interest rates typically range between 6 and 10 percent. The actual rate depends on the specifics of the acquisition and how well you demonstrate a capacity to make the monthly payments.
You may agree with the seller on interest-only or deferred payments that culminate in a balloon payment at the end of the loan term. This is meant to ease cash interest expense pressure on the business once ownership is transferred to you.
Buyer Tips for Seller Notes
If you are contemplating seller financing for your business acquisition:
Bring up seller notes early in the business sale process. The earlier you know if it’s a possibility, the better.
Get your accountants, financial advisors, lawyers and appraisers involved to go through the financials, paperwork and valuation. Have them walk you through the process, appraise the acquisition opportunity, protect your interests and determine favorable terms.
Join our buyer program to get help with financing your business purchase.
Conclusion
A seller note could just be how to bridge a financing or valuation gap in the acquisition of that small business you are interested in. Seller financing benefits both you and the seller. It can be structured in line with the specific requirements of your transaction. Understanding the structure, benefits and risks of seller financing is critical to extracting optimal value from it.
Interested in buying a small business?
Subscribe to our Listing Alerts for early access to new listings.
Will is responsible for helping sellers market their businesses to prospective buyers and providing hands-on support from offer to close. Using his background in mergers and acquisitions at Wells Fargo, he drives value and provides clients with the necessary resources, best practices and advice for a successful sale of their business.
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.
Calder Capital
Sam Domino