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An all-cash purchase can be ideal when plenty of strategic buyer capital is in the market. However, when private equity is in short supply, alternative types of financing, such as seller financing, are the best bet when acquiring small to medium businesses with less than $2 million annual turnover. Let’s explore the many pros and cons of seller financing business from the sellers’ and buyers’ perspectives.
According to industry statistics, 80% of small business sales involve seller financing. So, what would drive a seller to take less than 100% cash at closing for a business they have poured their blood, sweat, and tears into?
In a seller financing contract, the seller dictates the repayment terms. These payments are made monthly, allowing the seller to get significant ROI. For instance, with a 10% interest rate and a 5-year amortization, a seller can potentially earn an extra return of $50,000 or $60,000 for every $500,000 financed.
Selling a business triggers a long-term capital gain for the seller, and federal capital gains taxes soon follow. This tax, which can be as high as 20% of the sale price, reduces the net income from the sale price.
Most seller financing payments average 5 years with a high of 10 years plus a balloon payment at the maturity date. Conversely, receiving a lump sum from selling a business pushes the seller to a higher tax bracket. Spreading payments may reduce this possibility.
The business may face foreclosure if the buyer defaults on their loan payment. To make matters worse, the seller has no collateral for such a scenario. The only recourse for the seller is to sue the buyer, which can be lengthy and costly.
Seller-financing contract deals usually attract higher prices, the problem is, that they generate less immediate cash at closing. If you as the seller need the lump sum cash to pay off debts or to make other investments, then seller financing might not be the right fit for you.
Brian Slipka, a Forbes Council member, says that buyers consider owner financing a less risky investment strategy. According to him, seller financing indicates the seller believes in the business’s long-term success.
He adds that buyers are more willing to pay a higher premium for the business when they perceive less risk and growth potential.
Seller financing business buyers more lenient terms of financing than traditional banks would have. The terms of seller financing are also more flexible and agreeable. Also, sellers typically charge interest rates well below bank rates and with far longer amortization.
Suppose the seller isn’t comfortable with the buyer’s management style or doesn’t want to transfer the business to the new owner permanently. In this case, a conflict of interest may interfere with the business’s operations.
If you fail to make your payments, you can lose the business. This is because a seller may accelerate the process of taking back the business, faster than a traditional lender. After all, they have the expertise to operate it.
Seller financing for businesses presents unique opportunities and challenges. If you opt for this financing model, you need to weigh its upsides and downsides to realize a meaningful return on your investment.
