When it comes to selling a business, there are many things to consider – the value of your business, finding an ideal buyer, and working through the terms of the sale (and deciding if a seller note makes sense).
Regardless if you are selling your business to sophisticated buyers or family members, it’s worth learning how seller notes work. Seller financing is extremely common and included in the deal structure of 60 – 90% of small business purchases (Guidant Financial).
In this post, we’ll take a closer look at seller notes and explain everything you need to know before deciding whether they’re right for you.
What is a Seller Note?
A seller note (commonly called seller financing) is a type of financing arrangement where the seller of a business provides some or all of the financing in the deal.
In a seller note arrangement, the seller acts as a lender to the buyer and receives regular interest payments over a set period of time (usually 3 to 7 years), rather than receiving a lump sum payment at the time of the sale.
This interest bearing loan for a portion of the purchase can help meet the valuation gap between cash and senior debt from traditional lenders.
Depending on the company’s risk profile, a seller note can also be a way to get buyers more comfortable with ownership if there are potential risks at play (high capital intensity, cyclical nature, high customer concentration, changes to management team etc.).
This type of financing is a big factor in small business acquisitions, as studies show that the seller debt amount makes up 37% of the total purchase price on average (Pepperdine Private Capital Markets Project).
Seller Note Example: How Does a Seller Note Work?
Typically, small businesses are sold using a mix of equity and debt, as its very rare for a business buyer to have sufficient cash for all cash deal.
Often there is a combination of upfront cash, bank loans and seller financing to complete a purchase.
To make this real, let’s walk through an example.
Let’s say a business owner agrees to sell their business for $5M, but the buyer only has $3M to put towards the purchase price (using various cash/financing sources).
- After discussions, the seller agrees to include a seller note ($2M) as a portion of the purchase to bridge the gap.
- The seller note specifies the amount of the purchase price that will be paid upfront, with the remaining amount handled through deferred payments over time. Payment terms of the loan are negotiable, but typically have a higher interest rate compared to a traditional lender (i.e. bank loan).
- As a result, the company acts as collateral for the promissory note until the buyer has paid off the note with future payments (with the deed held in an escrow account). Most seller notes have both a personal guarantee and a UCC filing to secure the note.
- The buyer makes the initial payment to the seller, and the seller becomes the lender to the buyer, with the debt payments made on the loan according to the terms of the seller note.
- The seller receives the agreed-upon monthly payments over time, which provides them with a steady stream of income. In certain situations, the buyer and seller may agree on interest-only payments followed by a balloon payment to reduce the cash flow pressure on the buyer during the transfer of ownership.
- Once the loan has been fully repaid and reaches its maturity date, the buyer will have full ownership of the business and all company assets.
Is a Seller Note a Security?
Yes – a seller note is considered to be a type of debt security.
A debt security is a financial instrument that represents a loan, with the issuer of the security (in this case, the seller of the business) agreeing to pay the holder of the security a certain amount of interest over time, and to repay the principal amount of the loan at a specified date in the future.
A seller note is similar to other types of debt securities (such as bonds) in that they involve the issuance of a loan and the payment of interest over time.
On the flipside, a seller note is typically more flexible and customizable than other types of debt securities, as they can be tailored to meet the specific needs of both parties.
Why Would a Seller Carry a Note?
On the surface, a seller note might not feel like the best form of financing if you’re a business owner, but there are a few key reasons to consider it as you prepare to sell your business.
As a seller, one of the most challenging aspects of is working with the buyer to find ways to come up with reasonable financing options.
A seller note can make your business more attractive to potential purchasers who may not have the necessary funds to buy the business outright. This allows you to give the buyer an alluring financing option while still capturing some of the sale price upfront.
They can be a flexible form of financing to help find a win-win scenario for both you and the buyer. A seller note allows you to have some control over the loan terms and conditions of the loan (i.e. as interest rate and repayment schedule).
What are the Advantages of Seller Financing?
For buyers, this type of debt financing offers the following benefits:
- Lower upfront costs – By not having to pay for the entire purchase amount at once, buyers can spread out the cost over time and make smaller payments.
- Flexibility – Buyers may have more flexibility when it comes to negotiating terms since they’re dealing directly with the seller, rather than a bank or other financial institution.
- Fast approval times – Since there’s no need for third-party approval like a bank loan, the approval process usually moves quickly.
For sellers, the advantages of seller financing include:
- Higher sale price – Since buyers don’t have to pay for the entire purchase amount upfront, sellers can often get a higher sale price with a promissory note (typically 20%+) than if they required full payment at the time of sale.
- Security – Allows sellers to keep an interest in their business and receive regular payments, providing them with the ability to continually generate free cash flow and interest on the note.
- Control – By being involved in the financing process, sellers can ensure that their terms are met and have more control over the sale of their business.
- Lower taxes – Provides a tax break to the seller, as it gives them the such as the ability to spread the gain from the sale of the business over several years.
- Speed to sell – Typically accelerates the negotiation and closing process compared to a business offered with full cash.
What are the Risks Involved with Seller Notes?
Before deciding to use seller notes as a financing option for your business, make sure you have a strong grasp on the potential downsides, which we’ll cover below.
- The seller takes on some of the financial risk associated with the business. When you offer a seller note, you’re essentially acting as a lender. If the business doesn’t perform as well as expected, has an inability to generate enough free cash flow, or if the buyer defaults on the seller notes, you could lose some or all of your investment.
- A seller note is usually unsecured and subordinated to senior debt, which makes the debt riskier than bank loans or a business line of credit. This means if the buyer defaults and can’t pay off the debt, the other loans are repaid first.
- Since this type of financing relies heavily on buyer-seller relations and trust, there could be complications if either party feels like they’re getting a raw deal.
- Depending on the terms, you may be required to provide ongoing support or assistance to the buyer in order to ensure the success of the business. This could include consulting services, or ongoing advice and guidance.
What Should You Consider Before Using Seller Notes?
How can you mitigate the risks of seller financing?
- Start exit planning early: if you can make yourself less essential as the owner, it will ease the future transition. Focus on your business value drivers to improve your valuation and exit from a position of strength.
- Think about how you can set the new owner up for success. Spend time with them and do all you can to get them up to speed prior to the sale.
- If you decide to move forward with seller financing, think like a bank when you assess the risk of the potential buyer. To prevent high uncertainty and minimize risk, request a credit report and run a background check.
- Make sure your M&A advisors include clauses that address late payments and non-payment. A few options to consider: interest rate escalation rights, retaining the deed in a third party escrow account, and debt service coverage ratio requirements.
- File a Uniform Commercial Code (UCC) lien, which prevents the buyer from selling the business or its assets during the note period.
How many years will the note will be for?
While this is typically 5-7 years, this period is negotiable and depends on your comfort level and the buyer’s creditworthiness.
Should I offer seller financing or wait until it’s requested?
In many cases, it can be beneficial for the seller to offer financing—it can make the deal more attractive and could even help you receive a higher purchase price. However, every situation is different, so I’d recommend leaning on the guidance of your M&A advisors.
What interest rate is reasonable to charge?
Interest rates vary depending on the amount of risk and the ongoing market rate, but typically range between 6-8%. Since seller notes are unsecured debt instruments, there are typically higher interest rates to account for the greater risk level.
Should you use seller debt financing in your purchase price?
While I wish I could give you a definitive response, there is no one size fits all answer here. It’s important to carefully consider the potential advantages and disadvantages of using seller notes before making a decision.
There is a lot to consider, including the potential for the buyer to default on the seller notes, the need to structure the terms carefully in order to protect your interests, and the potential for the business to not perform as well as expected.
Conclusion
As we covered, a seller note can be a useful tool for making a business more attractive and increasing the overall selling price.
If you’re thinking about offering a seller note to bridge the gap for your purchase price, it’s a good idea to talk to your lawyer and M&A advisors who can help you understand the potential risks and rewards, and advise you on the best way to structure the seller note.
With the right advice and preparation, you can make an informed decision and set yourself up for success when selling your business. Good luck!
