Seller Financing in Business Acquisitions

Buyers often request Seller financing in business acquisitions as part of their purchasing strategy. They request sellers to provide a loan as part of the purchase agreement. This arrangement can benefit both parties. Buyers gain access to flexible financing options, while sellers can facilitate a sale, earn a return on investment, defer capital gains, and maintain cash flow. However, like any financial agreement, seller financing requires careful negotiation and risk management to ensure a fair and beneficial outcome for both buyers and sellers.  Paul Long, an expert in  SBA and business acquisition lending with Gesa Credit Union, and Seth Rudin, a Senior Mergers and Acquisitions Broker with IBA, vet the considerations for Seller Financing.

Understanding Seller Financing

In a seller financing arrangement, the seller essentially becomes a lender, agreeing to receive payments over time instead of requiring the buyer to secure full funding upfront. This can make it easier for buyers to complete a transaction, especially if they face challenges obtaining traditional credit union/bank loans. It also helps sellers expand their pool of potential buyers by reducing financing barriers.

From a buyer’s perspective, seller financing can provide more flexible terms than conventional credit union/bank loans. Lenders may also view seller financing as a sign of confidence, making it easier for buyers to secure additional financing from credit union, banks or investors.

For sellers, offering financing can make their business more attractive, speed up the sales process, and allow them to receive a steady income stream rather than a single lump sum.

Despite these advantages, seller financing carries risks. Buyers must ensure repayment obligations do not overburden them, while sellers must assess whether the buyer can fulfill the loan terms. A well-structured agreement with clearly defined terms can help mitigate these risks. Seth reminds the buyers he engages with that Sellers do not have a portfolio of loans to offset the risk of a buyer’s non-payment, whereas a credit union/bank does.

Key Terms in Seller Financing Agreements

The terms of a seller-financed deal should be carefully negotiated to protect both parties. The most important aspects include the interest rate, repayment schedule, and collateral requirements.

The interest rate should be competitive enough to provide a return for the seller while remaining reasonable for the buyer. Since seller financing often carries a higher risk than SBA or commercial loans, interest rates may be slightly higher than traditional lending rates. However, they should still be structured in a way that ensures affordability for the buyer.

Another critical element is the repayment schedule. Monthly, quarterly, or annual payments should be structured to align with the buyer’s projected cash flow. A repayment plan that is too aggressive can strain the buyer’s finances, increasing the risk of default. This also includes the amortization of the payment schedule. A 5-year loan can be amortized over 5 years on a monthly basis, or a 5-year loan could be amortized over 10 years with monthly payments due for 5 years and a balloon payment due at the end of the fifth year.

Collateral is often required to secure the loan. This could include business assets, personal guarantees, or other forms of security to protect the seller if the buyer cannot make payments. The agreement should clearly define the type and value of collateral to ensure both parties understand their rights and obligations. Sellers should carefully consider the collateral being offered, know if any liens are in place by other creditor or credit union/banks in a superior position, and understand the condition of the collateral. Oftentimes, buyers say the business is the collateral. For a service business, if the service company defaults, there will be no tangible assets and only damaged business and customer relationships. As such, Sellers must weigh the risk of a sale versus the risk of default.

Standby Seller Notes

Seller financing can take different forms, including standby loans and seller notes. These arrangements determine when and how the seller receives payments.

Standby loan: a type of financing where the seller agrees to delay receiving payments under certain conditions. In some cases, the seller may not receive payments until the SBA or business loan is fully repaid or after an interest-only period of 24 months. This type of agreement can help buyers secure additional financing, as lenders often require seller debt to be subordinated to SBA or commercial loans.

Standby Seller notes: another common financing structure. There are two main types: partial standby notes and full standby notes. In a partial standby note, this a type of financing where the seller agrees to delay receiving payments under certain conditions such as after an interest-only period of 24 months. The seller can receive some payments even if the buyer has not yet repaid their bank loan. This provides the seller with an income stream while allowing the buyer to meet their primary lending obligations and keeps the buyer motivated to pay off the loan sooner. In a full standby note, the seller does not receive any payments until the buyer fully repays their SBA or commercial loan. While this reduces risk for traditional lenders, it increases the waiting period for the seller to recoup their investment.

Seller notes cannot have a balloon payment when that note is being used as an equity injection by the buyer. However, if the buyer has contributed their 10% down payment in cash other seller notes can have a balloon payment.

This repayment order is usually a requirement from the lending institution. This is Seth’s biggest pet peeve with SBA lenders. The lenders often want to ensure they are paid in full before the seller, and in an SBA loan, that could be a 10-year waiting period. This should be avoided whenever possible. A 2-year standby loan is reasonable, and the Seller and the representing business broker should carefully assess and negotiate anything more.

Evaluating the Risks and Benefits

Both buyers and sellers need to evaluate the risks associated with seller financing before entering into an agreement. Sellers must assess the buyer’s creditworthiness, ensuring they have a strong financial history and a solid business plan. Buyers with a good credit score and a well-developed business operating strategy are more likely to meet their repayment obligations. Sellers should also consider the buyer’s ability to repay the loan, evaluating the company’s projected cash flow, the buyer’s personal guarantees, a life insurance policy to cover the risk of death, and any collateral that can be used as security.

On the other hand, buyers must ensure the financing terms are sustainable. Overcommitting to high-interest payments or an unrealistic repayment schedule can strain the business financially. Negotiating terms that provide enough flexibility to manage cash flow while ensuring the seller receives fair compensation is essential.

Sellers also need to evaluate their own financial situation before offering financing. They should determine whether they can afford to provide a loan without jeopardizing their financial stability. Seller financing can impact cash flow, particularly if payments are delayed under a standby loan agreement. Sellers should also consider the potential for default and have a plan in place for recovering their investment if the buyer is unable to meet repayment obligations.

Tax Implications of Seller Financing

Both buyers and sellers should be aware of the tax consequences associated with seller financing.

For sellers, financing the sale of a business may allow them to defer capital gains taxes, as they will receive payments over time rather than in one lump sum. This can potentially reduce the overall tax burden by spreading income across multiple years. However, sellers should work with a tax advisor to ensure they understand how different financing structures impact their tax liabilities.

Buyers should also consider how interest payments and loan obligations affect their financial statements and tax obligations. In many cases, interest paid on seller-financed loans may be tax-deductible, providing an economic benefit. However, consulting with a tax professional is essential to ensure compliance with tax regulations.

Seller financing can be a valuable tool in business acquisitions, offering flexibility for buyers and financial benefits for sellers. However, it is a complex transaction that requires careful planning and negotiation. Buyers should ensure that loan terms are manageable and align with their business’s financial capacity. At the same time, sellers must protect themselves from unnecessary risks by thoroughly evaluating the buyer’s ability to repay.

To structure a fair and beneficial agreement, both parties should work with experienced professionals, including financial advisors, attorneys, and tax specialists. Buyers and sellers can successfully navigate the process and create a mutually beneficial arrangement by understanding the key elements of seller financing—such as loan terms, repayment structures, collateral requirements, and tax implications.

For any SBA or Business Acquisition lending questions, contact  Paul Long, AVP of SBA Lending at Gesa Credit Union, at plong@gesa.com or 253-300-5414.

For questions related to selling a business, you can reach Seth Rudin, Senior Mergers and Acquisitions Broker of IBA, at seth@ibainc.com or 425-454-3052.