Everything You Need to Know About Financing When Selling Your Business

Your willingness to offer seller financing can greatly increase the likelihood of a successful sale, but seller financing has its risks. Under the right circumstances, it can be a financial boon, but sellers need to be aware of the pros and cons.

Pros For Sellers:

• Increased Purchase Price: If you offer seller financing then you can often increase the full purchase price, since you’re taking a higher risk on the buyer.
• Quicker Sale: Whether the business is completely seller financed or financed partially to help secure a loan through the SBA, seller financing increases the speed of closing.
• More Potential Buyers: Being upfront about offering seller financing could increase the total number of potential buyers, increasing the likelihood of a controlled auction for your business.
• Tax Advantages: You only pay taxes on the payments received, so your initial income taxes will be less than if you were paying on the total sale amount.

Cons for Sellers:

• Increased Risk: If the buyer defaults on the loan, you could end up getting a business back that’s worth less than when you sold it. Depending on the situation, this could lower the amount of money you receive for your business. This is why collateral and personal guarantees are so important.
• Maintain Vested Interest in Business: Since the buyer’s success is paramount to your loan being repaid, seller financing means you’ll retain an interest in the success of the business. For any business owner looking to make a clean break, seller financing may be a bad option.
• Less Immediate Capital: Seller financing means you’ll be deferring the majority of your payment to a later date, meaning you will have less money to reinvest prior to a sale.
• Subordinate to Lender: If the buyer defaults and the business closes down, the bank is first in line to receive any proceeds from the sale of any collateral.
• Standby for 2 years: Seller will receive either no payments for 2 years, or interest-only payments, depending on terms of standby.

Typical Seller Financing Terms

Each seller has a different mindset of what they want to get out of their business and when they need the cash for the sale of that business. However, there are some commonly accepted terms that can be a good rule of thumb when looking to negotiate seller financing. Terms for seller financing will commonly include:

• Loan Amounts: 30% – 60% of the purchase price (some sellers may do full financing with a substantial (15-20%) down payment)
• Term Length: 5 – 7 years
• Interest Rates: 6% – 10%
• Repayment Schedule: Monthly

How Sellers Protect Themselves

Since you’ve been running the business for some time, you’re probably confident in its ability produce income in the right hands. What you don’t know is how well your buyer will perform. Therefore, protections are put in place to protect your interest during seller financing. These protections may include:

Control of Business for Non-Payment
These are terms that state a seller will give the business back in the event that they miss payments. Generally, the terms will give a seller the right to retain control of the business within 30 or 60 days of the buyer default. 

Collateral
As a seller, you will want to file a Uniform Commercial Code, or UCC lien on all business assets to secure your interest as a lender. This notice states that your buyer owes you money and that their assets are pledged to you as collateral. Note: you will take second position to a bank if your buyer does default.

Minimum Inventory Levels
Sometimes, for businesses with large amounts of inventory, it's wise to include clauses in your contract that require the buyer retain a minimum level of inventory. This is to protect sellers from being left with no inventory in the event they have to reclaim the business due to a buyer default.

Expenditure & Financing Restrictions
Sellers may also restrict how buyers can spend and/or how much additional financing they can receive while still repaying the financing for the purchase of the business. Typically, buyers will be restricted from spending more than 1-3% above the seller’s largest expense period while they ran the business.

There are many types of SBA loans, but the most common and relevant to business sales is the 7(a) loan program.

Because the SBA stands behind the loan in the event of a default, loan approval is somewhat easier. The process, however, often takes longer because the borrower must be approved by both the SBA and the lender.

While buyers are the ones who need to obtain the loan, it’s important for sellers to understand what the lender and buyer are evaluating.

Why Many Buyers Utilize SBA

Conventional bank loans are rarely available for business acquisitions, and SBA loans are generally the least expensive sources of capital available to a buyer due to their competitive interest rates and long repayment terms.

It’s usually easier to get approved for SBA financing when buying an existing business compared to getting approved to fund a startup. This is because the lender can better judge the buyer’s potential to repay the loan by looking at their potential business’s track record.

Terms & Costs

Typical rates, fees and repayment terms:

• Loan Amounts: Up to $5 million
• Interest Rates: Rates vary based on what the current U.S. prime rate is. Base rate Wall Street prime rate plus 2.75%.
• Fees: SBA loans have a guarantee fee starting at 3% of the loan amount for loans over $150K. There are also fees associated with the loan, such as application fees and third-party closing costs. Third party reports such as environmental, business appraisal, etc.
• Repayment Schedule: The standard term for SBA loans is 10 years for a business acquisition loan and working capital and 25 years for real estate. A longer term means lower monthly payments and better cash flow.

What Your Business Needs to Have

Before a lender even looks at the buyer's information, they’ll want to see if your business qualifies for financing. Your business will need to have a strong financial track record, as well as clean and orderly books. Three years increasing revenues and cash flow is ideal.

You will be required to provide the last three years of business tax returns, three years of profit and loss statements, a copy of the lease, interim profit and loss statement, and a balance sheet. If there has been a decline in revenue or cash flow over the past three years, the lender may require a letter of explanation.

Even though all lenders must abide by the SBA SOP’s, each lender has the right to be more restrictive in its own procedures. Often, SBA lenders will request an inventory list, an equipment list, aged receivables report, etc. 

Seller Financing in SBA Loans

If a buyer doesn’t have sufficient cash savings to fund an SBA deal, the buyer can seller finance part of the loan. Most owners would rather cash out to have funds available for their next venture, but there are some advantages to seller financing.

For one, seller financing can help more buyers secure an SBA loan, opening up the potential pool of qualified buyers. Seller financing also gives both the buyer and the lender more confidence in the business, since it shows the previous owner is willing to take more risk.

Seller financing may also increase the sale-price of a business, since it is requiring the seller to take more risk. 

Keep in mind, when seller financing is used alongside SBA financing, the seller must be willing to take a “standby” position for 2 years and subordinate to the SBA lender. This means you won’t receive payments on the loan for the first two years (or will receive interest-only payments), and if the loan defaults, the SBA lender is in first position on proceeds from the sale of assets or collateral.

• NOTE: Seller financing is a major decision. Before you assist the buyer in financing a deal, make sure you have the opportunity to review his or her credit. We also recommend meeting with the buyer to ensure you feel comfortable.

Advantages of SBA for Sellers

1. Goodwill: Chances are, the value of your business greatly exceeds the value of its hard assets like equipment, inventory, furniture, etc. Intangible assets like trademarks and seller non-competes usually don’t count for collateral, but they can be financed through an SBA 7(a) loan.
   
2. Working Capital: Working capital gives buyers the ability to jump into the business and start operating at full steam as soon as possible. This is good for any seller who is carrying part of the debt in an SBA deal.
   
   
3. Long repayment period: SBA loans tend to have a longer maturity than conventional loans. The typical 7(a) acquisition loan will be paid out over 10 years. This gives the buyer more time to pay off the loan, and it gives them more certainty because they won’t have to refinance the loan in three to five years.
   
   
4. Real Estate: SBA Loans can also be used to finance the purchase of real estate and the loan can be up to 25 years.
   
   
5. No prepayment penalty: Banks aren’t permitted to charge prepayment penalties on SBA 7(a) loans, unless the loan has a maturity of 15 or more years. Even then, it only can last the first three years.

Disadvantages of SBA for Sellers

1. You can’t maintain a stake in the business: Often, it would be beneficial for the buyer to keep you involved in some way after the sale, either as a minority owner or as an employee. If a 7(a) loan is used, you can’t maintain a stake in the business after the sale. This means you can’t keep a minority ownership in the business. It also means you can’t stay on as an employee after you sell. However, you can agree to remain as an independent consultant for up to 12 months.
   
   
2. Earnouts aren’t permitted: In the event you and the buyer can’t come to agreement on the value of your business, the buyer may request an “earnout.” However, based upon the reasoning that you can’t maintain a stake in your business after closing, the SBA doesn’t permit an earnout.
   
   
3. Setoffs against seller notes aren’t permitted: The buyer may attempt to negotiate contractual protections in case there are issues that weren’t uncovered during the due diligence process. If you agree to seller finance a portion of the deal, the buyer may want a right to deduct damages from the note. Generally, the SBA doesn’t allow such deductions. However, setoffs are permitted if the note isn’t considered part of the equity injection that was required for the loan.
   
   
4. Personal guarantee of the buyer: The SBA requires each person who owns 20% or more of the business to personally guarantee the loan. This means the owners will be on the hook for the business’s liabilities if the business can’t pay its bills. This can be a drawback if the buyer, or their spouse, want to shield their personal assets from the business’s liabilities.

What Private Equity Firms Look for in an Investment

Private Equity Groups search for companies with solid management teams, solid and recurring customers, high margins, strong balance sheets and an ability to generate significant free cash flow.

The best candidates are private companies that are experiencing rapid growth, hold a leading position in their industry, have significant barriers to entry for competitors, and sell a differentiated product or service that commands a premium over the competition.

Typically, lower middle market private equity funds set a minimum level of EBITDA (Earnings before interest, taxes, depreciation, and amortization) such as $1, 2 or 5 million, but within the past few years, some smaller search funds have lowered their threshold and will review companies with an EBITDA above $500,000.

What Private Equity Firms Offer

PEGs may bolster the existing management team by replacing or adding specific positions such as a CFO to manage the company's financial affairs, improve operating procedures and internal controls, and serve as the financial representative when the firm is looking to sell the investment. PEGs also offer a source of liquid capital, resources, and industry expertise to help increase the value of your business.

A Private Equity Group is Right for You If:

• You don’t mind staying on after the sale, and you’re happy running a profitable company that's growing.
• You feel the business will be able to grow more with additional capital and/or expertise. You see lots of opportunities for growth that you simply can't pursue on your own.
• You’re interested in taking some money off the table while also getting the chance to increase the value of your remaining equity stake with an influx of capital.

How to Evaluate a Private Equity Group

It's essential for you to choose wisely if you sell a stake of your company to a private equity investor – you are essentially bringing on a business partner.  You should be looking for a PEG that has experience in your industry and a good reputation.

Evaluate the PEG’s track record and ask to speak with owners of previous companies the PEG has acquired. Be sure the PEG’s plans and projections are realistic. With over-ambitious plans to expand the business, it may overstretch the business. It’s also important that your management team’s future company goals align with the PEG’s goals.

Remember, the key isn’t necessarily to select the private equity group offering the highest price for your business today. Instead, look to partner with the group that will provide you with the opportunity for the highest overall proceeds. This would include the amount received initially and the amount you can reasonably expect in the future when the business is sold.