What Is Seller Financing, and Why Is It So Popular in the Mergers and Acquisitions Industry?
M&A brokers and advisors know that most businesses for sale offer some type of seller financing. In business sales, it covers a portion of the purchase price in the form of a loan. The remainder of the purchase price for a company may be covered by either a down payment, an outside loan, or some combination of the two. This is why down payments for business mergers and acquisitions are often larger than down payments for other purchases, hovering someplace around 30% to 40%.
The seller of a company essentially acts as the business buyer’s bank. That includes assessing the buyer for creditworthiness, charging interest, and covering the cost of the sale. Based on the agreement, you generally receive a large down payment, as well as regular payments for a defined number of years.
Seller financing in a business sale can remove the third-party lender obstacles, costs, or requirements, and it can help otherwise qualified buyers fund the purchase price of a sale. In so doing, it allows sellers to place their business for sale on the market for a higher price.
Because it is common and popular, sellers who are not open to seller financing arrangements immediately limit the number of potential buyers.
Seller Financing Due Diligence
A seller who intends to finance the sale must ensure that the buyer is not just qualified to run the business but also financially qualified to make the purchase. Confirming the buyer’s financial capacity includes performing most of the functions generally undertaken by a bank – i.e., reviewing the buyer’s:
- credit history
- financial statements
- history of bankruptcy
- banking information; and
- business plan for profitably operating your company
With a seller financing arrangement, all funding may come from you. If the buyer defaults, you may lose the carried part of the business purchase money. You will have to find a new buyer and possibly sell at a much smaller price, since a buyer who defaults may also have neglected other financial aspects of the business.
Initial Terms Structure
Most agreements allow a seller to repossess the business within 30 to 60 days if financing fails. This saves the buyer from a catastrophic business undertaking and prevents the seller from losing its investment.
Most seller financing arrangements carry other contractual stipulations. Many contracts contain a clause involving inventory, requiring new owners to maintain a certain quantity of inventory during the repayment period. This offers some assurance that the business will remain profitable, thereby increasing the odds that the seller will recover its investment. The buyer may be required to agree to different terms aimed at keeping the business profitable. The seller and buyer will negotiate these terms during the initial negotiation period, usually with the assistance of an experienced M&A advisor, broker, investment banker, or other business intermediary.
It’s Beneficial to Both Buyer and Seller
Both sellers and buyers stand to benefit from seller financing since this arrangement removes third parties and allows the seller and buyer to set agreeable terms. Buyers often prefer seller financing, and sellers interested in increasing the number of potential business buyers should consider this option. Some buyers disregard arrangements that do not include seller financing and will not negotiate to include it. Including seller financing as a key feature of your sale automatically widens your potential sales audience.
Sellers who offer to finance send a clear message about their business: They are confident in its short- and long-term prospects for success. That degree of confidence on behalf of a seller willing to take a risk speaks volumes about the business, further increasing buyer interest.
What Do Seller Financing Terms Typically Look Like?
A five- to seven-year length of financing is common. The amount that a seller should finance is a common sticking point, since many buyers also rely on outside financing. There are no hard and fast rules governing a seller’s contribution to the financing agreement; it’s common to finance about 60%. The rest may be covered by down payment or an additional loan, though larger down payments typically inspire more confidence in sellers.
Seller financing demands quite a bit of paperwork and thought; for most business owners, this adds to the hassle of a sale. But neglecting the fine details of a sale can lead to disaster and potentially lowers the price of the business or the favorability of financing terms. Partnering with a skilled attorney or an M&A advisory firm, broker, or investment banker — ideally, with both — protects all parties as well as the business itself. When the business is protected, so too are both buyer and seller, since the investment on which both sides have taken a risk depends on the business’s success and stability.
*This article was originally published in our partner’s IBG blog.