What Does Owner Financing Mean?
When an owner of a small business offers a buyer the option to finance a portion of the business sale price, it’s a transaction known as “seller financing.” In layman’s terms, the seller is acting as a bank, enabling a buyer to finance a portion of the purchase price over a set term with interest.
Owner financing, as it’s commonly called, offers benefits to both buyers and sellers. For the buyer who would not qualify for a business acquisition loan through a traditional lender, it provides an alternate form of financing. And for the seller, it deepens the pool of potential candidates.
Gretchen Jones is looking for a business to buy. The perfect opportunity presents itself when a close friend and mentor is looking to sell his business and retire. There’s a problem: Gretchen does not have the capital to cover the $1M asking price, nor does she have enough personal assets to pledge as collateral. As a result, she’s unlikely to qualify for a business acquisition loan. Is she out of options? Not necessarily.
Seller financing, or owner financing as it’s commonly called, is a tool business owners leverage to ease the burden buyer’s face in their quest to acquire capital for a business acquisition. It’s a financing measure commonly put in practice today. According to a recent survey, 74 percent of brokers and 58 percent of owners believe seller financing to be “essential” or “important” to closing small business acquisitions in today’s market.
How does owner financing work? What does the process look like? Is it a good option for your particular need? To answer these questions, we’ve put together this quick guide.
How Does Owner Financing Work & What Does It Mean?
The simplest way to think about seller financing for business acquisition is to regard the current business owner as a lender. The buyer strikes a deal with the seller, agreeing to pay back the total sale price (or most likely, a portion of it) over the course of a set term with interest.
Like a banker extending a loan to an applicant, a seller will perform a number of due diligence measures to assess the creditworthiness of a buyer. For example, a seller will most certainly asses a buyer’s credit report, ask for financial documentation, a business plan and other pertinent information to determine if a buyer is likely to deliver on the agreed upon terms.
A lawyer or business broker will then draw up the terms of the seller financing agreement, which is essentially a legally-binding IOU. Typically, owner financing terms are comparable to those of a business loan, with repayment terms between 3 and 7 years, monthly remittances and competitive interest rates usually falling within the 6 to 10 percent range. A down payment is almost always required, as is a pledge of collateral and/or a personal guarantee agreement.
Example of Owner Financing for a Business Acquisition
Here’s an example: The seller agrees to extend Gretchen owner financing for 50 percent of the purchase price and a 20 percent down payment. Per the seller financing terms, Gretchen will remit monthly payments for 10 years, with 7 percent interest.
- Business Sale Price: $1M
- Extended Seller Financing: $500,000
- 20 Percent Down Payment: $100,000
- Term: 10 Years (120 payments)
- Monthly Remittance: $4,644.34
- Total Cost: $557,320.70
- Total Interest Paid: $157,320.70
If an owner and buyer come to terms on a seller-financed sale, it can pay massive financial and convenience dividends for both parties.
How Owner Financing Benefits the Buyer
Buyers benefit from an owner-financed deal in numerous ways.
Provides Financing When Traditional Lending Products Are Not an Option
There’s no ifs, ands or buts about it: buying a business requires capital—and a lot of it. But obtaining a loan for a small business acquisition is no easy feat. Loan qualifications are strict, and any shortcoming can put buyers out of the running or push them into a “high-risk” bracket, which could mean a higher interest rate and a shorter repayment term. But in the instance of seller financing, the only person who needs to ‘okay’ the loan is the seller. If he or she is satisfied with a buyer’s credentials, the dream of business acquisition is still alive.
Cheaper to Close
When a buyer works with a lender to finance a business acquisition loan, origination, processing and administration fees are par for the course. In seller financing, these fees are eliminated, significantly reducing closing costs.
Business owners are more apt to negotiate on terms than a traditional or alternative lender would be. As a result, buyers can often settle on favorable rates and repayment schedules.
Vested Seller Interest
Since the seller has a vested interest in the success of the business (after all, the business needs to succeed to prevent default), the seller is often more than willing to stay on in an advisory or consultancy capacity for the length of the financing agreement.
How Owner Financing Benefits the Seller
The owner of a business assumes a great deal of risk when they agree to finance a loan (more on that later) personally, but there are many benefits associated with this form of business acquisition.
Higher Sale Price With Interest
Because a buyer avoids the high closing cost tied with traditional forms of financing, they are more apt to agree to a higher (or full-ask) sale price. And there’s the obvious benefit of accumulated interest. As was demonstrated in the above example, accrued interest is a significant source of capital for the seller.
Because payment is remitted to the seller in installments, versus a lump sum, the seller can spread out the tax hit over many years.
Larger Buyer Pool
If a seller is having a hard time finding a buyer with capital to purchase the business outright, seller financing is an excellent way to deepen the candidate pool.
The Drawbacks of Seller Financing a Business Sale
As with any form of financing, there are drawbacks to consider, particularly for the seller.
The biggest turn-off from the seller’s perspective is the risk involved in personally financing a loan. If a buyer defaults, the seller will lose out on interest income and will need to devote time and energy to the collection process. If unsuccessful, the seller may repossess the business—a business that is presumably in worse shape and of less value than at the time of initial sale.
Vested Interest in the Business
If a seller is looking to make a clean break from their business, then owner financing a business acquisition is not a good option. To ensure the continued success of the business, sellers may be called upon for guidance throughout the term of the agreement.
Less Immediate Capital
The seller will receive the proceeds of their business’s sale via installments, so they have less immediate capital to invest elsewhere.
To protect their interests and offset some of these risks, sellers can and should institute the following terms into their seller financing agreement:
One way to offset the delayed payment issue is to require a down payment that provides a significant chunk of immediate capital.
Control of Business with Non-payment Clause
To protect seller interest in the case of default, owner financing agreements generally contain terms that give sellers the right to take back control of the business within a specified period (usually 60 or 90 days) if the buyer continuously misses payments.
Collateral and Personal Guarantees
To further protect their interests, sellers should file a blanket UCC lien on all business assets and require the buyer to commit to a personal guarantee. This way, a seller can seize a buyer’s business and personal assets to recoup losses.
Seller Financing as a Complement to a Business Acquisition Loan
Though not unheard of, it’s rare for a seller to owner-finance the entirety of the asking price. A business owner usually agrees to finance between 20 and 50 percent. So seller financing is usually just one piece of the larger business acquisition puzzle, often combined with business loans, such as these (click on the links for more information on each):
Similar to a traditional bank loan, a business term loan provides flexibility and stability with access of up to $2M. Term loans give business owners up to 5 years to repay and feature interest rates as low as 7 percent.
SBA loans provide more opportunities to businesses who may not have been able to secure a traditional bank loan. While SBA loans are loans that originate from a bank, these banks are participants in the SBA loan guarantee program. Through this program, the Small Business Administration guarantees up to 85 percent of the total loan amount. As a result, SBA loans offer buyers favorable interest rates and lengthier terms.
Is Seller Financing Right for You?
Whether you’re an owner looking to sell your business or a buyer looking to acquire one, owner financing is a valuable tool that can offset the challenges of financing a business sale. If you do decide to pursue this type of transaction, never go it alone. It’s recommended that both parties enlist the professional services of a business broker, accountant and lawyer to assess the creditworthiness of candidates, draft the contracts and successfully negotiate terms.