What business owners and buyers need to know about seller financing

When a business owner moves to sell their first business, they are often met with frustration when potential suitors lack the funds they need to afford the asking price.

The truth is, most buyers aren’t able to purchase a business using 100% of their own funds, necessitating some sort of financing.

However, banking institutions don’t hand out money as readily as they used to, a trend that has led to a rise in seller-initiated financing. Before any company owner looks to offer a similar arrangement, they should heed the following advice.

Be vigilant

When a business owner decides to extend financing to a buyer, there is a lot of due-diligence that would normally be done by the bank that will have to be shouldered by them.

They’ll want to deep dive into the buyer’s credit history, financial reports (if they are being courted by another company), and other bellwethers of financial trustworthiness in order to sort out if an entity can be trusted not to default on their financial obligations.

Sellers will want to sure to insert language into any contract that will allow them to take back their company within 60 days if the new owner is unable to make payments.

Is it a mutually beneficial arrangement?

The best deals are ones that benefit both sides of the sale. Buyers should know that when a seller is willing to arrange a loan themselves, the enterprise is one that the seller knows will make money.

In this situation, the buyer gets a proven business that will allow them to turn a profit very quickly, and the seller gets to cash out while being confident that their creation will be in good hands.

Terms can vary greatly

Terms of a seller financing arrangement will vary from the consistent loan packages that banks offer. The key factor that determines the length of the repayment period is the proportion of the purchase price that is fronted by the seller. Generally speaking, the smaller the share of the loan the seller provides, the shorter the term will be.

Conversely, the greater the proportion of a loan that is covered by the seller, the longer it will take to pay back. Sellers should aim for the shortest term possible to minimize risk.

The seller will have to deal with buyer defaults themselves

Speaking of defaults, the risk of having of deal with one is considerably higher when a seller decides to offer financing to buyers.

Banks are notoriously conservative when it comes to extending loans for a reason: they are in the business of making money. If history is any guide, there are few sectors that are as efficient at the process than they are.

When a buyer can’t find a conventional funding source to fund their ambitions, they will turn to seller financing, regardless whether they are a good credit risk or not.

As such, it is important for the seller to trust their purchaser implicitly before loaning them the money they need to buy the business.