Buying a business through seller financing is an overlooked option. How does it work? How do both parties get a good deal?
- Seller financing refers to a mortgage agreement that cuts out third-party lenders. The buyer enters into a contract directly with the previous owner of the building.
- Seller financing terms are agreed upon by both parties and outlined in contracts and promissory notes.
- There are both advantages and disadvantages to seller financing for all parties. However, it’s a solid option if traditional finance agreements are limited.
Seller financing, also called owner financing, cuts out the third party – the bank or broker – in a purchase so that the seller is, in effect, the lender.
What is seller financing, and how does it work?
As the legal website NOLO points out, seller financing is frequently used in real estate, in particular during times when credit is tight and a potential buyer doesn't qualify for traditional mortgage financing.
Seller financing is often chosen as a route when traditional financing options are limited. Instead of the bank providing a loan to finance the commercial building, the seller finances the purchase. There may be multiple reasons that a traditional mortgage was not considered. For instance, the buyer may have poor credit or not enough financial history to qualify. The seller of the building sets the terms for the finance agreement, including potentially asking a higher purchase price than if a traditional mortgage was used. The process is also expedited since the agreement is private between the seller and buyer.
Contracts and promissory notes are still drawn up as part of seller financing. The terms are set and agreed upon by both parties, including the interest rates and payment schedules.
Both sides stand to benefit from seller-financed transactions. For the seller, it's a way to move a property faster and potentially get a higher return on investment. For the buyer, it can mean less stringent qualifying and down payment requirements, more flexible rates and better loan terms.
The same principles apply to buying a business, which includes not only the exchange of property but the transfer of other assets, such as customer lists and goodwill. It offers an additional advantage to sellers of more control in ensuring new owners maintain the business as they would want it.
Seller-financing arrangements are usually short-term, Forbes notes, as sellers typically aren't looking to collect payments for 30 years. There's often a balloon payment at the end of five years or earlier where the outstanding principal sum must be repaid.
BusinessKnowHow explains how such a deal might work. The purchaser provides some kind of down payment, primarily as a show of good faith and to reduce the overall principal and thus reduce total interest payments.
Let’s say the seller is willing to finance 90% of the purchase price, which for our example is $100,000. The buyer puts down $10,000. The seller loans $90,000 at an APR of 10%. Although the loan amortizes over seven years to lower the monthly payments, the balloon payment kicks in after three years, at which point the remaining balance is due.
Of course, different circumstances involve different terms. In most cases, regardless of the loan amount and repayment terms, both parties to the transaction can benefit.
The advantages for the buyer
- An affordable monthly payment (about $1,500 in our example) provides the new owner with some breathing room to use cash flow to pay bills and cover expenses while getting the business established under new ownership.
- The balance due at the end of three years (approximately $60,000) is more likely to obtain traditional loan approval to refinance than would the initial $100,000 loan.
- The interest paid isn't different than what would have been paid to a bank ($22,700).
- Sellers still have an interest in the success of what was once their business, which provides purchasers with a built-in source for advice and guidance that doesn’t cost them anything extra.
The advantages for the seller
- The seller earns interest ($22,700) on top of the amount asked for the business. In most cases, the interest earned is equal to, if not higher than, other investment options.
- Income taxes are lower than they would be if you were paying on the total sale since you are only paying taxes on payments received over time.
- The business can be sold to a buyer who, while qualified to run the business, cannot qualify for a traditional bank loan.
- The sale happens faster and the desire to get out of the business is realized more quickly.
- The seller maintains some stake in the business during a transitional period to help ensure the enterprise continues to succeed and serve customers.
Of course, there is always a downside. For the buyer, the drawback is taking on the risk of running the business plus the risk of making a monthly repayment of a significant sum. But, other than needing to pay back the principal with a short-term balloon payment, the risk isn't much different from financing any business purchase. Sellers, however, have a few things to think about.
Why owners might not want to offer seller financing
- There's more risk involved. When the purchaser finances with a bank loan, if the buyer defaults, that's the bank's problem. The seller already has the money. (One way to mitigate risk is to require business assets as collateral or demand a significantly higher down payment).
- Sellers maintain a vested interest in a business they may have preferred to make a clean break from.
- There is less immediate capital to reinvest. Sellers who need significant capital to invest in new ventures aren't likely to provide owner financing.
Given that, according to BizFilings, seller financing is involved in up to 90% of small business sales and more than half of midsize businesses; it would seem than in most cases, the pros of seller financing usually outweigh the cons.