There are many moving parts involved in the successful sale of a business, but determining how exactly the business will be paid for is a crucial – and challenging – one. Seller financing has become a popular option in recent years. About 50-90% of small to mid-sized business sales involve seller financing today. Let’s go over the options that buyers have when purchasing a business and talk about why so many sellers choose to offer financing.
What Are the Options for Financing the Sale of a Business?
Because many businesses are quite valuable, some of the options will involve multiple lenders or complex legal arrangements as well as ongoing business relationships between sellers and buyers. Here are the basic options that buyers have available to them:
All Cash
If a buyer has a large amount of capital available, he can offer to purchase the company outright and potentially get it for a lower price because the seller will have all of the money upfront and no long-term hassles or risks.
Earn Out
In an earn-out arrangement, the seller agrees to stay on for several years to help transition the business. The seller is either paid upfront under the condition that he remains, or he’s paid over time in the form of bonuses based on how well the company performs. It’s possible that the seller could receive more money than the original asking price if the company performs very profitably.
Leveraged Buyout
A leveraged buyout (LBO) was once a very common arrangement in which a third party, either a bank or investment firm, financed all or part of the purchase for the buyer. SBA guaranteed loans are sometimes utilized. Unfortunately, too many buyers defaulted on payments and banks or lenders had to restructure these loans, making them less attractive to offer. As a result, the criteria for buyers is much stricter than it used to be. Lender buyouts are still often used for buyers purchasing very small businesses. The structure of this type of financing tends to be quite complex.
Seller Financing
The final option is seller financing which also requires a considerable down payment, usually around 30-40% of the purchase price, from the buyer at closing. The remainder is paid out over time with interest via a loan the seller provides to the buyer.
How Does Seller Financing Work?
Typically, the seller agrees to provide financing in the form of a short-term loan, receiving scheduled payments for a defined number of years. This loan covers the cost of whatever remains of the sale price after the down payment.
In this type of arrangement, the seller agrees to act as the buyer’s bank which means that the seller must determine whether the buyer is creditworthy and how much interest to charge as well as cover the cost of the sale itself. Many buyers arrange other financing in order to cover the cost of the down payment.
Seller financing is popular because it takes the third-party lender, with its costs and requirements, out of the equation and can help qualified buyers afford to buy. For sellers, offering financing expands the pool of potential buyers considerably which allows them to get a better price for their business. The seller, in consultation with his lawyer and financial advisor, can determine the terms of the financing, including how large the down payment will be.
However, there are risks involved. The buyer could default on their payments and, if the business is failing, there may not be even the possibility of recouping the loss by assuming control again. This is why it’s crucial for sellers to carefully vet their buyers and require them to put up collateral – in the form of homes or other property – to mitigate their risk.
The downside of offering financing is that the business transaction is not concluded right away. The seller retains risk and will not receive the full price for his company for many years to come. Sometimes buyers try to renegotiate terms after the sale has been finalized as well – when the seller is in a position where he must cooperate or lose money.
Offering financing does significantly increase the possibility of receiving more generous offers, though. It’s easy to qualify a buyer, and sellers often receive beneficial tax breaks for going this route.
Financing is a complex but necessary part of the process of selling a business. Seller financing gives buyers and sellers more flexibility than working with a third party, but it opens up the seller to the risk that if something goes wrong, he will have real problems to deal with down the line.
If you would like help understanding your options for selling your business, including whether you should offer seller financing, please contact us at Prometis Partners. We know it’s complicated and are here to help walk you through any part of your transition or sale process.
