In this economy, even larger deals are seeing more non-conventional financing. Unless it’s an asset based loan, the banks are continuing to be restrictive in doing cash flow loans and it can be difficult for even larger business buyers to fund a business acquisition. Accordingly, seller financing has become quite prevalent in recent years.
The definition of seller financing is just how it sounds. A portion of a business acquisition is funded by the seller when the buyer cannot finance the M&A deal in full. The buyer repays the business owner back over time – otherwise referred to as an installment note. Many times this type of financing will be tied to an earn-out (see below) to protect against client concentration or other company specific issues.
With seller financing, the seller is put in a position where they no longer have to reduce the asking price if the buyer cannot fund the acquisition in full. The potential for earning interest in seller financing is often a worthwhile investment. Perhaps you would prefer to have all of the money on the day of the M&A deal’s close, but it may be beneficial to exchange cash up front for a larger return over time. Tax advantages may also available with a seller financed installment deal.
When seller financing comes into play, it requires a long-term relationship with the business and the buyer, post-close until the debt is paid off. Sometimes this can even include employment with the selling company. This can be both a positive and a negative, depending on how you look at it. This long-term relationship is an example of why it is imperative to only do business with a buyer that you would like to continue to work with in the future. It should be noted that the current SBA SOP calls for seller participation for no longer than one year.
A word of caution is in order relative to taking an installment note. A lender will typically put UCC (Uniform Commercial Code) Filings in place to protect the assets being lent against. A UCC Filing is similar to a home mortgage. If the buyer is securing a bulk of the funding through their own equity and a primary lender, you may be subordinated to the primary lender putting you in a second secured position behind the bank – beware!
It is also important to choose a buyer that you believe will have a positive influence on the company, because seller financing often consists of an earn-out. An earn-out is when the buyer pays back a higher amount in relation to the success of the business or long term retention of key clients.
Trust in the buyer is an essential aspect of the M&A deal, since the seller will not receive all cash at closing. Seller financing is almost like allowing the buyer to give the business owner an IOU in exchange for the company that they promise to pay back in increments.
This being said, the risk increases when selling a business completely through seller financing. We recommend that you personally finance no more than one-third of the selling price in order to avoid the possibility of financial loss. You may also enter into an installment sale where there is a longer amortization of the principal but with the balance due in a balloon payment before the note matures.
Don’t look at seller financing as a last resort to selling a business. Instead, it can be a useful option for receiving the desired asking price and attracting more buyers in a tough economy. However, be sure to come to a legal agreement that clearly spells out your remedy(s) in the event of a default in payments.
An M&A intermediary can help you make the right financial decision in your business transaction. Contact George & Company for all of your business selling and financing needs.