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Traditional funding methods may not always be suitable or accessible options for online business acquisitions. Seller financing is an alternative approach that can work well for both the buyer and the seller in the right situation.
This article covers the details of seller financing as it relates to online business buyers and sellers. You’ll learn the potential benefits and drawbacks, and see when seller financing does or does not make sense.
What is Seller Financing for a Business?
Seller financing allows the buyer to acquire a business while relying less on traditional financing sources. In this arrangement, the seller of the business effectively provides a loan to the buyer, granting them the opportunity to purchase the business without turning to finance companies, banks, or institutional investors. By utilizing a seller note, the buyer gains the flexibility to repay the seller over a designated period of time along with interest.
Typically, the seller receives a percentage of the money upfront and agrees to finance a portion of the business acquisition. The buyer is responsible for making periodic payments (usually monthly) to the seller based on negotiated terms.
For example, if the business’s selling price is $1 million, the buyer might pay $600,000 upfront in cash, and the remaining $400,000 may be covered through seller financing. The buyer would be responsible for paying off the debt in monthly installments at an agreed interest rate over a set period of time.
Seller financing makes an acquisition possible when the buyer does not have enough cash or is unwilling to put up enough cash upfront. While SBA loans and other more traditional funding options are sometimes available, some limitations make certain acquisitions, businesses, or buyers ineligible.
Related reading: What is an Earn-Out When Selling an Online Business?
How Seller Financing Works
The process begins with negotiation between the buyer and seller. Both parties must agree on the purchase price, the amount that will be seller-financed (often a percentage of the total price), the interest rate, and the repayment schedule.
Here’s a breakdown of the steps:
- Agree on Terms: Both parties negotiate and agree on the loan terms, including the amount, interest rate, and repayment schedule. This is often done with the help of legal and financial advisors to ensure the terms are fair and compliant with relevant laws and regulations.
- Draft a Promissory Note: The seller provides the buyer with a promissory note. This is a legally binding document in which the buyer promises to repay the loan according to the agreed-upon terms.
- Secure the Loan: The loan is usually secured with the business assets, meaning that if the buyer defaults on the loan, the seller has the right to seize the business assets.
- Complete the Acquisition: The business is sold and transferred to the new owner. Typically, the buyer will pay a portion of the sales price in cash at closing.
- Payments: The buyer makes periodic payments to the seller according to the terms of the promissory note. Payments typically include both principal and interest.
- Release of Liens: Once the loan is fully repaid, the seller releases any liens on the business, and the buyer owns the business free and clear.
The seller should assess the buyer’s creditworthiness and, in many cases, the buyer’s experience and competence in managing the business. This method of financing demands a high level of trust and transparency between the buyer and the seller. If the buyer fails with the business, the seller may not receive full repayment of the debt, so sellers must be careful.
The Advantages of Seller Financing for the Business Owner
Most sellers want to receive 100% of the funds in cash upfront. This is often possible with small acquisitions below, but deals over $1 million are more likely to involve some sort of financing. And in a buyer’s market, many smaller deals will also involve seller financing.
Marvin Karlow, Senior M&A Advisor at Raincatcher, says, “The bottom line is that there are very few “all cash” deals. Sellers who come to terms with the reality that some portion of the purchase price will be deferred are well-positioned to successfully consummate a transaction. Sellers who can’t or won’t get left at the altar.”
Although most sellers may prefer cash, offering seller financing offers some potential benefits.
1. Increases the Chances of the Business Selling (Larger Buyer Pool)
Seller financing expands the pool of potential buyers who can afford to purchase the business. This is because it reduces the amount of cash that a buyer needs upfront – making it possible for more people with less cash on hand to make an offer.
Since seller financing allows for more flexible financing terms than traditional bank loans, it’s appealing to buyers who may not be able to secure a standard loan.
By offering seller financing, you broaden your pool of potential buyers, increasing the chances of selling your business.
2. Creates Income from Interest Payments
One of the main benefits of providing seller financing is the opportunity to generate additional income from interest payments. When you finance the sale of your business, the buyer agrees to pay you back in installments with interest. This means that, over time, you’ll receive more money from the sale due to the accrued interest.
3. Potentially Reduced Tax Liability
Tax implications can be a significant concern when selling a business. With seller financing, you could potentially reduce your tax liability by spreading the income from the sale over multiple years.
Instead of receiving a lump sum payment and paying taxes on it all at once, you may benefit from a more manageable tax burden as you collect installments from the buyer over time.
Note: It’s important to consult with a CPA or tax professional who can guide you based on your specific situation.
4. Potentially Higher Selling Price
In some cases, offering seller financing can result in a higher selling price. This is because buyers may be willing to pay more for a business that offers flexible payment options and allows them to avoid obtaining conventional financing.
Additionally, the larger buyer pool and increased demand can contribute to a higher selling price.
5. Makes a Purchase Possible if Other Funding Isn’t Available
As mentioned earlier, traditional funding options may not always be available for online business acquisitions. In these cases, seller financing can allow a buyer to acquire the business when they otherwise wouldn’t have been able to.
6. Shows That the Seller is Confident in the Business’s Future
One notable advantage of seller financing is that it indicates the seller’s confidence in their business. A seller’s willingness to finance the purchase demonstrates faith in the business’s viability and future success.
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Drawbacks of Seller Financing for the Business Owner
1. Greater Risk
Although there are potential benefits for the seller, there are also risks involved in offering seller financing. By providing a loan to the buyer, the seller takes on the role of a lender. This means that if the buyer defaults on the loan, the seller may never collect all the money they’re owed.
If the loan is secured with the business’s assets, the seller may be able to recoup some of their losses or take back ownership of the business. However, it’s possible that the business will be in rough shape at this point and may not have much value. Additionally, the seller may have to go through a lengthy and costly legal process to collect funds or assets.
2. Missed Opportunities from Not Having the Cash Upfront
While the seller will benefit from interest payments, the money tied up in financing the acquisition cannot be used elsewhere. This means that the seller may miss out on opportunities that would be available if the deal was for 100% cash upfront.
3. Interest Rate Risk
The interest rate set for the loan is another factor that can affect the potential benefits and drawbacks of seller financing. If interest rates rise, it could result in a lower return for the seller.
Risks of Seller Financing for the Buyer
1. Ongoing Payments Can Limit Capital for Other Expenses
When a buyer opts for seller financing, they must make ongoing monthly payments to the seller, similar to making mortgage payments to a bank. This limits the availability of capital for other expenses and investments, as a significant portion of income may be directed toward these payments.
This can impact the new owner’s ability to grow the business since they may not have the necessary funds to invest in employees/freelancers or other resources to help grow the business.
2. May Prevent a Clean Transition
In some cases, seller financing can create challenges during the ownership transition. Sellers still have a vested interest in the business since they receive ongoing payments from the buyer. This can result in conflicting opinions and decision-making, which can hinder the new owner’s ability to fully take control and make necessary changes for growth.
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How Can Sellers Protect Themselves from Buyers Not Paying?
While seller financing does come with risks, there are several strategies that sellers can adopt to reduce the chances of these potential pitfalls.
Require a Significant Down Payment
One of the best ways to mitigate risk is to get as much money upfront as possible. A significant down payment demonstrates the buyer’s commitment and reduces the seller’s potential losses.
Thoroughly Vet the Buyer
Before providing financing to a buyer, performing due diligence is crucial. This process might involve checking the buyer’s credit history, understanding their business experience, and evaluating their plan for the business. It’s also essential to understand their financial standing and assess their ability to make the payments.
Secure the Loan with Collateral
Securing the loan with collateral can provide an added layer of protection. For the sale of an online business, the collateral might be the business’s assets (including the website). This means that if the buyer cannot make payments, the seller has the right to reclaim the assets.
Hire a Lawyer to Draft the Agreement
A well-drafted sales agreement can provide significant protection for the seller. Engaging a lawyer to draft this document ensures your interests are protected.
When It Makes Sense to Offer Seller Financing
Offering seller financing can be a strategic decision for business owners under certain circumstances. Here are some instances when it makes sense:
- When the market is slow: During a sluggish market, attracting buyers can be challenging. Offering financing can encourage more potential buyers who may otherwise not have the means to purchase your business outright.
- When you want to sell quickly: If you’re aiming for a speedy sale, offering seller financing can widen your pool of potential buyers, increasing the likelihood of finding a buyer more quickly.
- When you’re confident in the business’s future success: If you believe that the business has great potential for growth and profitability, providing financing can be a strategic move to secure a higher selling price without taking excessive risk.
- When the buyer has a strong track record: If a buyer has a history of success in the industry or relevant experience, offering financing can be less risky since they are more likely to succeed after the acquisition.
- When traditional funding options aren’t available: Conventional funding may not be available for all online business acquisitions.
When it Doesn’t Make Sense to Offer Seller Financing
There are also instances where offering seller financing might not be in your best interest:
- When you need all the cash immediately: If you require immediate funds from the sale of your business, seller financing isn’t for you. Payments are made over an agreed timeline, meaning the amount of money you get upfront will be smaller.
- When the buyer has poor credit: If a potential buyer has a poor credit score or credit history, they may be a high default risk.
- When the buyer has limited business experience: If the buyer lacks experience in running a business or in the specific industry, there may be concerns about their ability to manage and grow the business successfully.
- When the business is declining: If your business is experiencing a decline or has uncertain future prospects, it might be risky to offer seller financing. If the business continues to decline under new ownership, the buyer may default on their payments.
Seller financing presents a combination of benefits and drawbacks for sellers. Like any financial decision, it requires careful thought, thorough due diligence, and keen judgment. Every transaction is unique, influenced by various factors, including market conditions, the buyer’s experience and creditworthiness, and the seller’s financial requirements.
Financing often presents an obstacle for acquisitions, and seller financing can be a potential solution. In certain situations, sellers may need to be open to seller financing to close the sale.
If you’re considering seller financing, it’s worth speaking to your attorney and accountant for personalized advice.