When you sell your business, you have the option of conducting a cash sale or an installment sale. A cash sale is when the buyer is going to purchase your business and pay you the full asking price on the day of the closing. This could either mean they already have the full amount of cash available or it could mean they’re getting financing on their own from a bank or third-party lender. This would allow you to get paid in full while the monthly payments are made to those financing institutions by the buyer.
However, if you conduct an installment sale, then you become the lender for the buyer. This means you provide them with seller financing where they agree to make monthly payments to you in exchange for them taking immediate ownership of your business. The consequences of this can be both good and bad. It depends on how trustworthy the buyer is and how well they’re able to run your business and keep it profitable. Like a bank, you’ll want to screen the buyer carefully by doing a background check, credit check, and possibly review their track record of running other businesses.
You are only allowed to use installment notes on capital assets which can depreciate and ones that you’ve held for over one year. This usually means that you can sell real estate and intangible assets like goodwill with installment payments. But when it comes to accounts receivable or your business inventory, this doesn’t qualify for installment payments because you must pay taxes on those for the same year in which you sell them. With intangible assets, it is different because the Internal Revenue Service allows you to spread out your tax burden over the course of the installment contract. That is why those assets qualify for installment payments when you go to sell them.
The Internal Revenue Service lets you allocate the total purchase price to various assets that you’re selling, depending on what class these assets fall under. This allocation method will help you avoid paying a higher tax rate on the installment payments that you receive. It is up to the buyer and seller to agree on how the price gets allocated. Sometimes the allocation can benefit the buyer and other times it can benefit the seller. To have it benefit you, try to get the price allocated to the tangible assets that are over one-year-old.
There are a lot of benefits to seller financing your business to a buyer. For starters, you’ll be able to attract many more buyers when you list your business for sale and mention in your advertisements that seller financing is available. A lot of buyers don’t have enough cash to purchase a business upfront in full. By financing your asking price, you will attract many qualified buyers who have a huge desire to run your business and make it an even bigger success. Another huge benefit of seller financing is that you can set a bigger asking price than you would if it were a cash sale. This means you’ll make more money at the end of the installment note’s term.
Many buyers won’t even consider purchasing a business if seller financing is not available. They want to make sure the seller still has a stake in the business just in case something goes wrong. Buyers are just as worried about honesty and integrity as sellers are. There are sellers out there who might lie to a buyer by selling them a business which they falsely claim is profitable. If the buyer were to purchase this business in cash, the seller wouldn’t be involved anymore and then the buyer would be stuck with a bad business. So, it makes the buyer trust you more when you offer them seller financing.
As a business owner, it can get risky to offer seller financing to a buyer. Aside from the fact that you won’t get paid in full right away, you also must go through the trouble of screening the buyer and making sure they qualify as a suitable buyer for your business. Since you don’t have the personal resources to investigate a buyer’s background, you’ll likely have to pay accountants, lawyers, and even private investigators to do it for you. This will cost you more money out of your pocket just to verify that you have a good buyer. And if you don’t, then you’ll have to spend this money again for the next time a prospective buyer comes along that you need to investigate.
The biggest concern you’ll have with seller financing is ensuring that your business stays up and running. Even if a buyer has superb credit and references, it doesn’t mean they can make a success out of your business. In fact, they could run it into the ground if they don’t follow your advice on how to operate it. Sometimes buyers like to come up with their own ideas and implement them into the business. Unfortunately, those ideas usually contradict the owner’s advice which could then ruin the business. If this happens, the buyer could just walk away without too much invested. You, on the other hand, will be in real trouble because the value of your business will be destroyed, and you would have hardly made any money from the sale.
The owner of a sole proprietorship is only going to have capital assets to sell. There is no actual entity to sell and transfer over to the buyer. You will only be able to seller finance the intellectual property, vehicles, real estate, and equipment of the business. Since all these assets will be in your name anyway, you can create a simple purchase agreement between you and the buyer. There is technically no business being sold here because the only entity is you. So, you must use your own name on all paperwork and list in the agreement which assets are being sold.
Related: How to Sell a Sole Proprietorship
Limited Liability Company
A limited liability company does not traditionally get sold with financing. The reason being is that an LLC does not issue or sell stock to its company. Even though an LLC is usually established as a separate entity from its owner or owners, it is often regarded as a pass-through entity for tax purposes. But you are still allowed to sell it with seller financing if you want to. However, the capital assets will probably be worth more to the buyer than the actual entity itself. It depends on how big the company is and if it’s already making money. Just remember that in a multi-member LLC, all the members must approve the seller-financed sale. If one of them does not, then you won’t be able to do it.
A corporation traditionally issues and sells stock. If all the major shareholders of a corporation agree to sell the business with seller financing to a qualified buyer, they are really just selling all their shares to the buyer. What they will do is issue a promissory note on those shares before they are transferred to the buyer. This promissory note will have a stipulation that in the event the buyer does not make their scheduled payments, the original major shareholders have the right to get those shares returned to them. The exact details about this will get worked out when the agreement is made.
If the corporation is a small business, the board of directors may sell 25% of their shares to the buyer per year. Meanwhile, the buyer will get to join the board of directors and learn first-hand about how to run the day-to-day operations of the business. All the major stakeholders of the company will be there to walk the buyer through everything. This ensures their success at running the company while ensuring the shareholders get the full purchase price that is eventually coming to them.
Related: Stock Sale Agreement Template
Video: Structured installment sales are an alternative method of disposing of highly appreciated business interest or real estate. Structured Sales Expert John Darer discusses the capital gains tax deferral alternative and takes you through the Structured Installment Sale process.
There are ways in which you can assure that the sale will be an advantage for you as the seller. When you set the term length of the contract, it should be between 5 to 7 years at the most. It is certainly okay if the buyer pays you sooner than 5 years because at least you’ll get all your money faster. But if you have a contract that is longer than 7 years, a lot can happen to the business in this timeframe. A 5 to 7-year term is more likely going to allow the buyer to honor their end of the deal.
Aside from setting a higher overall asking price, you should still charge between 6% and 10% interest on the loan amount. That way, you can make even more money off the deal once all the payments are in. But just to ensure that the buyer is serious, don’t give them 100% seller financing. You should always require a down payment of at least 30% of the total asking price. Then you can seller finance the other 70% to the buyer. By doing it this way, you ensure that the buyer is committed to running the business properly or else they are going to lose their down payment.
Finally, in addition to the buyer’s down payment, consider accepting other collateral from them as well. This could be any cars or real estate properties that the buyer owns and certainly doesn’t want to lose. The more invested the buyer becomes in the transaction, the less likely they are going to default on the agreement. For those buyers who can’t make a down payment, then you should require more of their personal or other business property as collateral.
Related: Legal Steps to Selling a Business