In a perfect world, all sellers would finance the sale of their business and realize the additional financial gain associated with the loan interest. It seems like a great opportunity until the buyer decides not to pay the seller. So what are seller financing pros and cons today?
First, most small business owners have an immediate need for the cash or capital generated by the transfer of the business. The seller may be planning to purchase another business, retire or need the money for any number of other reasons.
Any of these reasons make financing the purchase and sale difficult for the seller. The seller’s CPA would be quick to point out certain tax advantages to be enjoyed by the seller but at the same time reluctant to recommend financing most buyers.
One of the problems for the seller offering financing is sufficient collateral. Ideally, the seller would have collateral value equal to the loan amount. This would allow the seller to recover the full value of the promissory note in the event of the buyer’s failure to pay. However, emergency liquidation of the buyer’s collateral can be difficult and may not rise to the level of the outstanding note balance.
Another form of collateral involves the “right to re-enter” the business. Under this provision, the seller retains the right to take the business back should the buyer fail to pay. Most sellers find the idea of coming back to the business unacceptable. Additionally, the buyer may have caused considerable financial damage to the business and/or lost key staff members.
So how can the seller participate with financing but avoid the lion’s share of the liability?
The usual compromise is for the seller to finance a small percentage of the purchase price; maybe 10%, that can be used by the buyer as part of the purchase down payment. The remaining amount of the financing often comes from a Small Business Association (SBA) 7A loan.
The buyer will have to meet requirements such as relevant business experience, required down payment, credit score and business planning. It is important to note that the SBA does not loan money but rather guarantees the lender a percentage of the loan amount. The seller will have to agree to be in a subordinated position which means he/she will be paid secondary to the lender. The seller will also find little or no collateral assigned to his/her promissory note.
So, we can agree that the lender and the seller must be careful to select a capable buyer with sufficient capital to weather a storm along the way to repaying the loan. This cooperative effort has helped many sellers transfer their business and move on to the next challenge. It is not free of risk, however, proper evaluation of the buyer and the business financials can reduce the risk to an acceptable level.
What are your thoughts?
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