It is often the case that a purchaser of a business does not have the resources for a full cash sale and will request that the seller finance some of the purchase price. This can be advantageous for both parties, but requires that the parties consider a number of issues, as we highlight in this article.
Advantages to the Seller
While many sellers are initially reluctant to consider financing the sale of their business due to the risk that the purchaser will not pay as agreed, sellers who do engage in self-financing deals typically find that they can obtain a higher price for their business. In addition, by financing a percentage of the purchase price, a seller increases the pool of potential purchasers, making it easier to locate a buyer for their business. Finally, some sophisticated buyers will refuse to consider the purchase of a business without some level of seller financing because they want the seller to have some “skin in the game”, which indicates to the buyer that the business is viable.
Advantages to the Buyer
The advantages to the buyer are generally more obvious. First, a seller-financed sale permits the buyer to consider purchasing a business valued at a price point beyond their own immediate resources. If the buyer negotiates a reasonable interest rate, they can avoid unattractive sources of financing, such as use of credit cards or lines of credit to purchase the business. Finally, if the buyer is seeking a bank or small business loan to cover some of the purchase price, the lender will often desire seller financing of some percentage of the costs, which indicates to the lender that the seller believes in the soundness of his or her company.
What Terms do Sellers Typically Desire in Exchange for Financing?
While each situation is unique, a seller’s note often carries an interest rate which is at or below current bank rates, depending, in part, on the perceived level of risk or other assurances that the loan will be paid in a timely manner. In addition, sellers will usually require some or all of the following terms as conditions of seller financing:
- Resumption of control of the business for default on the loan;
- Buyer assets as security, such as real estate;
- Buyer’s personal guarantee.
Since the seller’s obligations are typically fulfilled upon execution of a note, his or her greatest concern when providing seller financing is that of the buyer defaulting on the loan. In order to mitigate the impact of such a situation on the seller, he or she will typically wish to include terms permitting him or her to retake control over the business in the case of default by the buyer. This typically occurs within 30 to 60 days of an uncured default. The seller may also require periodic reports from the buyer with regard to the financial stability of the company until the loan balance is satisfied. For companies which utilize a substantial amount of inventory, sellers sometimes seek provisions requiring that the buyer maintain those inventories at or above specific levels.
When it comes to collateral to secure the loan, sellers are typically most interested in using the buyer’s real estate as security, which allows the seller to foreclose on the property in the event of the buyer’s default. However, if the buyer does not own real estate or has little equity in their property, then stocks, inventory or other assets held by the business are all commonly used as security in seller financed transactions. Some seller financed transactions do not include any assets as security, but may include the owner’s personal guarantee, meaning that if the company defaults on the loan, the owner’s personal assets can be reached to satisfy the debt.
Whether any of these or other conditions are required by the seller will often depend on a number of factors, including the relationship between the parties, the amount of financing being provided by the seller, the length of the loan, and the level of risk to the seller if the buyer defaults. If the seller is financing a fairly small amount of the purchase price, which is scheduled to be paid within a relatively short time frame, and the level of risk of default is fairly low, then the seller may simply rely on his or her remedies at law, such as a breach of contract claim, which could be brought if the buyer defaults. This, along with a provision providing that the buyer pay the attorneys’ fees and costs to pursue such a claim are typically quite effective in preventing a buyer from defaulting on a loan. In general, there are many methods which may be utilized to ensure timely payment on the loan.
Common Legal Documents in a Seller-Financed Transaction
Depending on the circumstances, there are several legal documents that should be drafted in a seller financed sale of a business, including:
- Letter of Intent setting forth the preliminary framework for negotiating terms of the sale;
- Purchase or Sales Agreement including the final negotiated terms of the sale;
- Promissory Note;
- Security Agreement or Deed of Trust if real property is used as collateral;
- Any applicable lease or transfer documents, such as vehicle and real estate title documents;
- Bill of sale transferring title of other business assets to the buyer;
- Non-Compete Agreement if not included in the Purchase or Sales Agreement;
- Bulk Sales documents if inventory is included in the sale; Click here for information on California Bulk Sales Laws;
- IRS Form 8594;
- Employment Agreement if owner remains a consultant or employee of the company following closing of the transaction.
In summary, buyers and sellers both stand to benefit from seller financing. However, it is important for each party to retain experienced business lawyers to assess their situation independently and advise them on how to best protect their interests in such transactions. Even for a simple sale without security, there are many issues to consider which an experienced professional can identify and address. Don’t go it alone, our trusted and knowledgeable business attorneys offer a complementary evaluation for most legal services and work diligently to protect each clients’ interests. Contact us today, you’ll be glad you did.