Businesses are listed for sale by their owners all the time. Not only that, but there are a lot of buyers out there who are looking to purchase businesses for themselves. So, why don’t more business for sale transactions take place? The reason is because business owners don’t usually offer any seller financing options to buyers. Instead, they rely on buyers to secure their own financing or to simply use cash to purchase the business.
Since most buyers don’t have the kind of cash that is needed to purchase a business outright, they most often need to borrow the money from a bank or private lender. However, banks and private lenders no longer like giving out big loans to people who just want to buy someone else’s business. It’s one thing to borrow money to start your own business, it’s another to borrow money to purchase a business. Banks got so hurt by doing this in the past that they rarely do it anymore.
The aspect mentioned above leaves buyers in the awkward position of having to take out a personal loan and pay high-interest rates. Chances are, they won’t be able to secure a personal loan that would cover the costs of purchasing an entire business anyway. Therefore, buyers have no other option but to find a business owner who will provide seller financing to them.
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Seller financing doesn’t mean that the owner gives the buyer money to purchase their own business. It means that the seller works out an arrangement where the buyer makes monthly payments to them in exchange for getting ownership of the company. Usually, the buyer will make a down payment and then a sign a promissory note which outlines the total number of payments that are due over time and the conditions of what will happen if they default on those payments. It is almost like a real estate transaction in a way where a buyer purchases a home from a seller who offers owner financing. The only difference is that this is a business rather than just a piece of real estate, even though real estate may be included if the company owns any property.
How it Works
Sellers aren’t just going to sell to anybody and they certainly aren’t going to hand over their company to just anybody without having some sort of collateral attached to the contract. Sellers need to take a few precautions to ensure the buyer is serious and will likely follow through with their end of the deal. That is why a seller must always require a down payment from the buyer because a scammer or delinquent likely wouldn’t pay money upfront. However, the down payment amount should be at least 33% of the total sales price. The reason being is the length of the contract will not be for 15 or 30 years like a real estate transaction. Instead, it should be for around 5 or 7 years while requiring a balloon payment at the end of the term which covers the balance owed. Most legitimate buyers will agree to this because they’ll likely feel that they can turn the seller’s business around and make it profitable within a 5 to 7-year period. If they can do that, then they’ll have no problem paying off the remainder of the balance owed at the end of the contract’s term.
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Sellers should never arrange an owner financing contract with the buyer by themselves. It is always wise for a seller to hire the services of a lawyer who can structure the contract properly to serve their interests. This lawyer can also work with the buyer to find out their financial situation and their financial ability to make the payments outlined in the contract. Often times, the owner and lawyer will negotiate with the buyer to create financial terms that both parties can agree on. This includes an agreeable payment schedule, loan period, internet rate and anything else that will make it easier for the buyer to fulfill their end of the contract. Sometimes a floating interest rate will be offered to the buyer, which is where the interest rate starts out low and then gradually increases each year. This is helpful to buyers when they first take over the business because they are just learning the ropes of running the company and may not be making too much money in the beginning.
The lawyer can file the promissory note with the secretary of state’s office in the state where the business is based. That way, the seller doesn’t have to figure out the proper legal procedure in doing that. Also, the owner will almost always hold huge collateral in the deal, which comes in the form of the entire company itself and its assets. So, for example, if the buyer defaults on the payments and doesn’t fulfill their end of the contract, the seller can come back and reclaim their business or its assets. Of course, it will cost them some money to go through the legal channels of getting their business back. But it is still better than losing the entire investment they made into their business by not getting it back.
Video: Dallas Business Broker, Bill Whitehurst, helps those thinking of selling their business understand why an owner must be willing to accept some amount of owner financing when selling their business.
The most important thing about a seller financing deal is that the seller is the one who feels the most comfortable about it. If you try to make the deal more beneficial to the buyer than yourself, then it could come back and hurt you later on if the buyer defaults. That is why a lot of owners require additional collateral besides just the business entity and capital assets. An owner may request additional security from their buyers such as their primary residence or any other real estate they might own. That way, if the buyer defaults on the contract then the seller can obtain ownership over the buyer’s house in addition to reclaiming their business entity and capital assets.
Pros of Seller Financing
The biggest reason why a business owner would sell their company with seller financing is because it greatly increases their chances of finding a buyer. Owners cannot expect to have high rollers with millions of dollars in the bank to just come along and purchase their business, especially if it’s a small business. Most buyers who purchase small businesses don’t have hundreds of thousands of dollars in the bank to pay cash for a business. So, a business owner who offers financing will give these buyers an incentive to want to make a deal to purchase the business.
Sellers also understand that financing their business could mean they’ll make more money at the end of the contract. Since financing deals often have bigger sales prices than cash deals, sellers can usually ask for a bigger price for their business and most likely get it. They’ll also be collecting interest payments on the monthly installments as well. And if for some reason the buyer defaults on the contract, the seller can reclaim their business and keep all the payments they received up until that point.
Aside from finding a buyer and collecting more money on the sale, owners can just take a break from their business and not worry so much about managing it. Even though they’ll still be legally attached to the business, they won’t have to tend to the day-to-day operations of running it. All they have to do is sit back and collect the monthly payments while someone else manages their business for them.
Cons of Owner Financing
Owners take on a lot of risks when they offer seller financing to someone who wants to purchase their business. For starters, the seller can’t just walk away from their business forever. This would be possible to do with a cash sale but not with a financing sale. If you offer owner financing to a buyer and they end up defaulting or running away from the business, this means that you’ll have to go to court and pay legal fees to get the business back. Not only that, but you’ll have to take back the business in the shape that the buyer left it in. If they totally ruined the business or its brand, it may be hard to step back in and make the business profitable again. You could very well end up having to close down the business entirely because of the way the previous buyer ran it. On top of that, you’ll be responsible for the debts and liabilities of the company as well.
If you want the seller funding deal to be done right, then you’ll have to invest money in hiring an attorney and/or an accountant to help you construct the contract. There are so many interests that you need to protect in case unforeseen situations happen in the future that jeopardize the deal. For example, you need to have a clause in the contract that prevents the buyer from selling off your company’s capital assets to someone else while they’re still making payments to you. Plus, you need to have the buyer take out a life insurance policy and name you as the beneficiary in case they die unexpectedly. If you don’t do this, then it’ll be the same as the buyer defaulting on the contract if they were to die. As you can see, you need to cover so many different scenarios in your contract to ensure that you’re totally protected.
Tax Benefits of Seller Financing
A business owner who sells their company with owner-side funding will pay a lot fewer taxes to the Internal Revenue Service than they would if they sold the business for cash. The IRS considers any property sold through financing to be an installment sale. This means your capital gains tax liability gets spread out over the course of the contract. If you were to just sell the entire business in cash within the first year, you’d be paying a short-term capital gains tax on the entire amount. On the other hand, let’s say you receive monthly installments on your business for seven years. You will only be taxed on the payments you received per year rather than the whole thing. That means you don’t have to shell out as much money at once in order to pay your taxes.
Business owners may be able to qualify for tax deferrals on the sale of their businesses if certain conditions are met. First, a seller must be willing to accept installment payments that count toward the purchase price of their business. Secondly, the seller must allocate all the deferred payments toward the capital assets of their business that are taxed as capital gains. In other words, the buyer is going to be receiving the capital assets of the business as they are making payments every month. These capital assets are ones that you’ve likely held for a long period of time and they count as an expense for you. So, when they buyer is making the payments, you can apply those payments toward the value of the capital assets rather than the value of the business. This will save you money because your captain gains tax rate will be lower on assets held for a longer term.
Related: Tax Considerations When Selling a Small Business
Go With Your Instincts
As a small business owner, you can do all the research in the world on a buyer to see if they are trustworthy. You can conduct a background check, credit check, and financial check to get a clear picture of who they are and how much money they have. But in the end, you still have to make the determination of whether or not to offer seller finance to them based on your gut instincts. Often times, buyers will pressure the owner into giving them a seller financing deal because they show a true interest in purchasing their business. But you should never feel pressured into agreeing to any kind of deal where your business is concerned. If the buyer tries to pressure you, then say forget it and try someone else. Legitimate buyers, on the other hand, will typically act professional and won’t try to high pressure the seller into doing anything. They’ll simply negotiate by stating their situation and then the seller makes the choice of whether to go through with the deal. This is how the scenario should play out for you when you meet with a potential buyer. Just don’t let your eagerness to sell your business end up clouding your good judgment. Because if you do, then it could cost you many thousands of dollars.
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