If you talk to bankers that do small business acquisition lending, many will suggest that a seller who isn’t willing to carry at least some financing is not confident of the ongoing success of their business because if they were then they would leave some “skin in the game”. I think that’s a ridiculous and self-serving comment. A business owner who extends financing to a buyer will usually be required to subordinate the seller note to the bank loan. So what happens if the seller has a great operation, and then they sell it and the buyer makes a bunch of dumb changes and runs the business into the ground? Being in second position will likely mean that the seller will be left holding the bag through no fault of their own.
The bank is obviously in a stronger position by having the seller carried note in place – so I understand why they push for it. Why doesn’t the bank simply require the buyer to put in more equity, rather than inappropriately push for seller financing? Because the bank would rather the buyer retain more financial resources which will increase the probability of being able to successfully repay the loan. I have found that the expectation of significant seller carried financing is often reinforced heavily by many business brokers. In fact, many business brokers will insist that a business seller carry financing if they want to sell.
Why would a business broker push for significant seller financing? It’s simple . . . their job becomes much easier. The more seller financing that is offered, the more attractive the deal will be and the wider the pool of buyers. The business broker will be paid on the total consideration paid on the business including the seller carried note, yet if the buyer defaults two years into the note, it will have no impact on the broker who has already been compensated at the completion of the sale.
It’s true that a seller who is willing to carry financing will make their business more marketable. Also, for some businesses (particularly those with higher risk characteristics) it may be difficult to get a deal done without offering financing. Still, what about the well-performing, well-run, established, stable business with relatively low risk factors, and strong opportunities for growth? Should the seller carry financing on that?
When I represent a very strong business and another professional, a buyer, or a buyer’s representative suggests that in order to get a deal done the seller will have to carry significant financing, I tend to push back pretty hard. If it’s a bank that is insisting on seller financing, I will help the buyer to find a bank that won’t require this.
Research that I conducted on a large sample of small sold private businesses from a business comparable database indicates that on an average deal 43% of the consideration will consist of seller financing. Contrast that with Codiligent’s historic average of less than 10%.
A seller takes on considerable risk when carrying financing. After selling the business, the seller will no longer have control of how the business is operated and the buyer may make changes that inhibit the business’ ability to repay the note. The seller also doesn’t have the diversification advantage that a bank has – the seller is holding one note as opposed to the large number of business loans that the bank has in its portfolio. As previously mentioned, the fact that the seller note will be required to be in second position behind the bank means that if a buyer does get into financial difficulty and the business is liquidated the seller may not recover any assets, and if they do, it will only be after the bank is paid.
So who should carry financing and who shouldn’t?
If you have a top notch business and you don’t mind the potential of a longer marketing time frame I would suggest NOT carrying financing, or at least limiting it to less than 10-20%. In contrast, if there are some significant issues with your business then it may be advantageous to offer more significant seller financing. Furthermore, regardless of whether the business is top notch or not, if a more rapid sale is desired carrying a seller note may help you more easily achieve your exit timing goals.
Here’s some general advice I give to clients about seller carried financing:
- Make sure you get enough cash at closing that if the buyer defaults on the note you will still feel like you did OK financially on the sale.
- You should get an interest rate on the note that is at least equivalent to what a bank would charge since a seller carried note carries more risk.
- If one of your motivations for extending financing is to defer capital gains taxes you may want to ask yourself whether you believe capital gains tax rates are likely to be significantly higher or lower in the future.
The majority of Codiligent’s business sale clients end up closing their transactions with little or no seller carried financing. Contact Codiligent if you are a prospective business seller who would like to explore whether achieving an all-cash, or nearly all-cash, sale for your business is realistic.
Codiligent Business Brokers – Portland, Oregon based business brokers representing sellers of businesses with $500k – $20 million in annual revenue. To schedule a free consultation to discuss the possible sale of your business you may contact Eric Williams at 503-535-8817 or E@codiligent.com
