Few people who wish to buy a business have the kind of cash it takes to pay 100 percent of the purchase price up front. Some sort of financing is almost always necessary. The traditional path to financing the purchase of a business involves sitting down with a banker, filling out a loan application, and waiting to see if you qualify. Once the loan is approved - assuming everything is in order - you have the money you need to proceed. Whether you are buying an existing business, starting one from scratch, or purchasing a franchise, the path to ownership almost always runs through some sort of financial institution, whether commercial bank, credit union, or private equity firm. But there is another route available to you, if you happen to be buying a business that is already up and running - having the existing owner provide some or all of the financing.
In its simplest terms, seller financing means that the current owner of a business offers to carry some or all of the debt incurred by the buyer when taking over the enterprise. Let’s say the sale price of XYZ Company is $5,000,000, and the owner - Mr. Z - has no outstanding liens or mortgages. In other words, he owns XYZ free and clear. Ms. B, the prospective buyer, has only $1,000,000 to put toward the purchase. Mr. Z agrees to take the million as a down payment and has Ms. B sign a promissory note for the difference. By entering into this agreement, she now owns XYZ in its entirety while Mr. Z has $1,000,000 in the bank, plus a guaranteed income stream based upon monthly payments from Ms. B against the $4,000,000 debt (plus interest).
Over the past couple of years, traditional sources for financing the purchase of a business have been severely compromised. Lending today is tighter than ever; interest rates are high and credit rules are such that the old adage, “Banks seem to lend money only to people who don’t need it,” is perhaps truer than ever. Qualifying for a loan is an arduous task, and a lender will be very fussy not only about your own financial situation, but also the perceived health of the business you wish to buy. But eliminating the need to deal with a bank is not the only reason to seek out seller financing. Oftentimes a seller is highly motivated to find a buyer and sees this option as an ideal way to attract serious attention. The buyer can frequently obtain better terms from the seller - a longer period to pay back the loan, and an interest rate more attractive than the current market - while not having to jump through so many hoops to qualify. One more advantage - the seller remains a party to the company’s ongoing success. Mr. Z wants to make sure that Ms. B does well so she will remain current on her payments against the $4,000,000 she owes.
It is not unusual to see situations where a seller will finance at least half the value of the purchase. This number will go up based upon several factors, including how much the seller may owe to others (real estate mortgage, equipment financing, etc.), or what he or she expects to do with the proceeds. If Mr. Z is planning to retire, he won’t mind taking the majority of the funds in monthly payments, as the deal would look very much like an annuity to him. But if he is buying another business, he may be less inclined to float a loan for the entire purchase price - unless, of course, the business he is buying also involves seller financing! While every deal is different, you can expect to see at least a five- to seven-year payback, and usually an interest rate in the eight to ten percent range. Using a straight-line amortization schedule and the aforementioned purchase of XYZ Company, a $4,000,000 loan at 8.5 percent over seven years would require Ms. B to pay Mr. Z $63,345.90 per month for 84 months. If this amount does not seem to comfortably fit within the company’s expected cash flow, the two parties may instead agree to lengthen the term and thereby reduce the amount owed each month - perhaps in exchange for a slightly higher interest rate. For example, changing to a ten-year note at 8.75 percent, the monthly payment drops to $50,130.70 a month. That extra $13,000 in Ms. B’s pocket could make a big difference in the day-to-day operation of the business. Also, most seller-financed notes allow the buyer to pay it off early without penalty. If Ms. B does better than expected, she can make bigger payments every month or save up for a lump-sum payoff a few years ahead of schedule.