Seller Financing in Business Sales: Don’t Rule It Out Completely if You Want to Get your Deal Done

Hardly any business sellers start out planning on providing part or all of the financing for the sale of a business.  However, seller financing is very common among green industry and other small businesses today.
Despite most sellers’ hesitance to provide seller financing, it is very common.   In a recent survey of business brokers, brokers reported that sellers provided over half of the financing in 40% of the transactions closed in the last year.
One reason that seller financing must be considered is that it may affect  the price that a business will sell for as well as the length of time it will take to sell a business.  The reason is pretty straight forward.  In many cases, the inability of a buyer to complete a transaction is not due to a problem with the business being sold, but a problem with the ability of the buyer to obtain adequate financing for any of a variety of reasons, particularly during periods of “tight credit.”   The seller then is left with the choice of letting a potential sale get away or lowering the price until the purchase becomes financeable.  Structuring an element of seller financing is often a solution that preserves value.
Another factor that may cause business sellers to consider a component of seller financing is the fact that it may permit a seller to take advantage of more tax planning opportunities by permitting it to move part of the gain on the sale of a business into a later period, deferring taxes while perhaps generating a higher return than the seller can get from alternative investment opportunities.  This often represents a very real economic incentive to consider seller financing.
In today’s lending environment, many lenders require an element of seller financing before they will consider making a business acquisition loan.  For example, some lenders will want the buyer to make a 20% down payment and  the seller to finance 20%, leaving 60% for the lender to finance.
Specifically, loans guaranteed under the U.S. Small Business Administration’s 7(a) program are a major source of small business acquisition financing.  While there is not an absolute requirement that there be seller financing for such loans, that is the norm.  Under current requirements, the SBA will generally require 25% “equity” in a project, with the “equity” including the buyer’s down payment and qualifying seller financing.  In order for it to qualify, seller financing can have no required payments of principal or interest during the first two years.  Interest can still accrue during this period.   Based on these requirements, some transactions will be structured with two different elements of seller financing, one which qualifies as “equity” under SBA guidelines and one that doesn’t.
There are many ways to structure seller financing.  A common structure would be a note which is amortized over five to ten years, but with a balloon payment due after two to five  years.  This gives the buyer the time to get the business going and, perhaps, to refinance his acquisition financing under more favorable terms.
Another approach is to make a portion of the purchase price payable under a formula – a percentage of revenues or earnings for example. This structure is sometimes called an “earn-out.”  This has the advantage to the buyer of matching the required payments to its actual cash flows.  If the seller is confident of the future performance of the business, this kind of a structure may be highly desirable to both parties to the transaction.  A buyer will often be willing to pay a higher price with an earn-out.  This is an approach that can be used to resolve a disagreement over business valuation.
Seller financing will generally be junior in security to third-party financing, so it should be carefully structured to produce the best result.  The following are some considerations which can improve the standing of seller financing:
·    The seller financing can be secured by a specific asset.  This is unusual, but if real estate is involved, for example, the real estate may be structured as a separate transaction with a security interest.
·    Seller financing can be structured with balloon payments required within two-to-three years reducing the risk that holding paper over a longer period may produce.
·    Balloon payments may be required when certain pre-established performance measures are met.
·    A requirement can sometimes be included that earnings or cash flow over a certain level must be used to pay-off the seller financing.
·    In a few cases, a seller may be in a better position if it provides all of the financing, preserving its security interest and rights in the event of default.
While we usually think of seller financing as some thing that is primarily associated with one relatively small business acquiring another small business, many large corporate buyers attempt  to use seller financing for a variety of purposes, including maintaining credit lines, increasing returns on acquisitions, giving substance to noncompetition agreements and reducing risks associated with acquisitions not working out as anticipated.
If carefully structured, an element of seller financing will often help a seller realize its objectives by increasing the valuation of the transaction and accelerating its timing, while limiting the risk that one would normally associate with providing such financing.