How Seller Financing Works
You're selling your business and the seller requests seller financing. Should you finance the buyer who is purchasing your business or should you avoid seller financing at all costs? This article explains the basics of seller financing, including the benefits and the risks associated with seller financing.
When it comes time to sell their business, many entrepreneurs are hesitant to consider the possibility of seller financing. The truth is that seller financing might not be the right option for every small business owner. But for some, it might be a prudent and profitable investment.
Here's how seller financing works. As part of the deal to sell a business, the seller agrees to finance a portion of the sales price over a specified term at a specified interest rate. The buyer pays a down payment upfront, and continues to make payments according to his agreement with the seller. To secure his investment, the seller takes a lien against the business until the balance is paid in full.
Keep in mind that seller financing isn't an act of charity toward the buyer. It is a business decision with all the benefits and risks of any other business decision.
The benefits of seller financing can be significant for both the seller and the buyer. First, it gives a buyer who might not meet the stringent requirements of a commercial lender the ability to purchase your company. That's good news for the buyer.
But, it's also good news for the seller, because in return for the seller's willingness to finance the deal, the buyer is willing to pay a higher price for the business than he might have been had he financed it through a bank. In fact, statistics have shown that seller financed deals typically have a 15% higher sales price than those that are commercially financed.
A higher sales price may seem extortionist, but it isn't. The fact that the seller is willing to finance the deal gives the buyer confidence that the business is viable and profitable.
The other big benefit of seller financing is that the seller continues to profit from the sale through interest. It is not unreasonable to expect the interest payments to effectually double the sales price in less than ten years.
Obviously, seller financing does entail a certain amount of risk, especially for the seller. The biggest risk is that the business will fail before the buyer makes full repayment. True, the seller holds a lien on the business, but in many cases the lien doesn't provide enough security for the full loan amount. To mitigate this risk, many sellers require additional forms of collateral such as a lien on the buyer's personal residence.
Another associated risk is that the seller could potentially end up owning the business again if it fails. This may seem like a negligible risk because it doesn't necessarily involve a financial loss for the seller. However, it means the seller runs the risk of being actively involved with the business for a far longer time period than he/she may have intended. Even though this probably won't happen, the seller needs to prepared to be attached to the business until the repayment term has come to completion.
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