Seller Financing: 9 Ways Protect Yourself

1. Check The Buyer's Background

It may sound obvious, but when it comes to getting paid the money the buyer owes you, the most important thing you can do is verify that the buyer is qualified.

Too many sellers - in their rush to sell ASAP - ignore warning signs the buyer sends throughout the selling process.

In the next section we will discuss Due Diligence. While most people associate due diligence with the buyer investigating the seller, and we will talk about what you can do to investigate the buyer's financial qualifications as well.

But, in addition to checking the credit reports, personal assets, work experience and personal references of the buyer you should also be assessing the buyer on a personal and professional level.

Don't be afraid to interview the prospect early on in the selling process just as you would a job candidate.

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Usually, the more qualified and prepared the buyer is, the more understanding they are of your concerns. Conversely, the buyer who is lying about past businesses successes or their financial capabilities will balk at any attempt to get to facts.

Here are some warning signs that buyers often give when they are looking at your business. If more than 2 or 3 of these apply to your buyer, he may not be the type of person you want to lend money to:

  • They delay or avoid any discussion of their financial qualifications.
  • They seem more interested in how much money you will take off your asking price than they are in the actual operations of the business.
  • They expect/demand all sorts of financial information from you up front without providing any proof they can actually afford the business. In other words, they want the flow of information to be all one way.
  • They are very forthcoming with financial information about themselves and it is bad (or inadequate to buy your business)
  • They have bought or started more than one business in the past that failed.
  • They are undercapitalized. As we stated previously, buyers tend to underestimate how much money they will need. If they have just enough cash to cover the down payment, then they are undercapitalized.
  • Lack of experience. If they never ask any insightful questions and never raise any concerns/objections, it's probably not because your business is perfect but because they don't know what to ask.


2. Don't Give the Buyer a Legal Excuse to Not Pay You

Some short sighted sellers try to hide certain negative aspects about their business thinking that once the business is sold they are off the hook. From a legal standpoint that may not be the case.

Always be forthright with the buyer.

The Sales Contract will include a section for Representations and Warranties - statements of fact about the business such as:

  • All the financial information provided to the buyer is correct
  • The seller owns the assets listed in the sales agreement
  • All tax returns have been filed and there are no taxes owed unless specifically listed
  • All liens and encumbrances have been listed

These and many other statements can be part of the sales agreement. Of course your lawyer will help you with this. Always be honest with your lawyer about any problems with the business - they can't protect you from legal problems if they don't know the true state of the business.

Related: The 6 Legal Steps to Closing Sale of Your Business

Avoid making any promises or guarantees about the business' future performance or the health of the industry. Once you sell you can't control these things anyway.

3. Make Sure the Payment Terms Are Realistic

It may be tempting to try to squeeze every last dime out of the buyer and then shorten the repayment period to 12-18 months. But if the result is that the buyer can't meet his monthly payment obligations then you haven't done yourself any favors.

Related: Seller Financing Agreement Template

Remember, the buyer will be paying himself and you out of the cash the business generates. The financing plan has to be based on realistic expectations about the business' performance in the near future.

Just as buyers tend to underestimate how much cash it will take to get into the business, they tend to overestimate how quickly they can increase profits. In truth most businesses experience lower sales and profits immediately after the new owner takes over.

You know your business better than anyone, so don't let an overly optimistic buyer tempt you into an unrealistically short payoff period - better to wait 5 years to receive all your money and actually receive it than to set up a plan where the buyer starts missing payments almost immediately.

Here are some guidelines when it comes to seller financing:

Get a Down Payment of at Least 30% but Shoot for 50% - 60%

The first reason you want as big a down payment as possible is obvious: the more the buyer puts down, the more they have at risk in the purchase and the harder they will work to make it a success.

The buyer will be making monthly payments to you out of the cash flow the business generates. So the payments must be low enough that the buyer can pay himself a decent wage and have enough left over to pay you. The down payment, therefore must be big enough to lower the monthly payments into this affordable range.

Even if you do not need a lot of money up front to live on and want to spread the payments out to lower your taxes, you will still want a sizable down payment to cover your expenses related to the sale itself. Consider these expenses that you will face after selling:

  • Taxes - sales tax, stock transfer tax, real estate stamp tax, and other taxes due at the time of the transaction.
  • Loans - you'll need enough after tax cash to pay off those business loans not assumed by your buyer.
  • Fees - appraiser, attorney and accountant's fees, and in some cases broker's commissions.
  • Word of Warning: Most buyers overestimate how much they can afford to pay down.

Many buyers will look at how much money they have in the bank and think this is what they have available for a down payment.

But just as you will have legal and accounting expenses associated with the sale, so will the buyer. Then there are the living and operating expenses the buyer will need in reserve when they first take over the business. It's common for a business to experience reduced sales and profits in the months immediately after a new owner takes over.

An over anxious buyer may very easily underestimate how much money they will need in those first few months.

While this is technically "their problem", it can have serious consequences for you when it comes to receiving timely payments each month.

Related: Promissory Note Template

So make sure that the down payment is big enough to put the remaining payments in a range the business can support but not so big that the buyer is cash strapped the day they take over.

Along these same lines: you should know where the buyer is getting their down payment from. You may feel secure in the knowledge that the buyer has paid you 60% down, leaving only 40% to be covered by future payments.

But if they borrowed that 60% down payment from their rich uncle they have actually financed 100% and the chances they can meet monthly payments on both loans is unlikely.

Limit the Repayment Term to 3-5 Years

Your goal in setting up the financing should be to lower your risk as much as possible. The longer you stretch out the repayment period, the greater the chance that something will go wrong and you won't get fully paid. Obliviously, the greatest threat to your payments is that the buyer may run the business into the ground.

Also, economic conditions can change and, through no fault of the buyer, the business is no longer generating as much profits as in the past.

Always Charge Interest

It turned out that only 25% of the businesses listed here offered any type of seller financing. Yet of those that do, a surprising number of these sellers were willing to not only finance the sale of their business but to do it interest free!

There are several reasons why this is a bad idea.

First of all, offering 0% financing is just giving away money! Buyers expect to pay interest on the money they borrow.

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If you sell your business for $200,000 with $100,000 down and finance the remaining $100,000 for 5 years at 8% interest, you will make $21,162 in interest. There is no reason to give that away.

The buyer may try to negotiate with you to get a better rate but they are still prepared to pay something.

Which brings us to the second reason you should always charge interest on the money you loan - it gives you flexibility in negotiation. You can always lower your interest rate (which is preferable to lowering the price) as part of the negotiation's give and take. But if you offer no interest up front it gives you nothing to offer during negotiations because you have already given it away.

And the last reason you should always charge interest is that the IRS may tax you as if you did collect interest ... even if you didn't. It's called Imputed Earnings and it allows the IRS to estimate the amount of money you would have earned if you had changed a fair rate of interest and then tax you on those earnings.

4. Life insurance

You can have the buyer take out a life insurance policy with yourself as beneficiary.

5. Acceleration Clause

An acceleration clause states that if a buyer fails to make a payment on time, the entire balance becomes due immediately.

6. Additional Collateral

If the buyer has a personal residence with significant equity, commercial real estate or other investments, you should ask him to put them up as collateral.

7. Personal Guarantee

Just like a bank, you can require the buyer to personally guarantee the loan when you sell your business. You should also get a personal guarantee from the buyer's spouse. This prevents the seller from transferring all their assets to the spouse in order to avoid paying you.

8. Sales Contract

Depending on the circumstances when you sell, you may want to restrict the new owner's acquisitions, expansions and sale of assets until you are paid in full.

Related: Collection of Legal Documents Needed for Selling a Small Business

9. Escrow

If you are selling a corporation or LLC, you and the buyer may agree that your corporate stock or LLC certificates will be held by a third party - such as an escrow agent - until the buyer has paid you in full. If the buyer doesn't make good on his payments the escrow agent would then return the stock certificates to you.

Related: Escrow Holdback When Selling a Business

More on the topic: Selling Your Business With Seller Financing

About the author: Hannah Butler works as a content writer. Besides, she likes sharing her business experience in the form of articles. In this case, she has her own section on In the future she is going to start writing a blog in order to describe her working methods to others.

Published by ExitAdviser


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