Seller financing when buying a business

In short

A friend of mine once bought a small hardware store and never walked into a bank. The man who owned it simply let him pay over time. If you are thinking about buying a business, you have probably wondered whether the seller could play the part of the lender. He can. This is called seller financing, and it means the seller accepts a promise to pay instead of all the cash at closing. The buyer signs a note, a written promise to repay with interest, and the seller waits for the money. Get the terms in writing, and have a lawyer and an accountant read them first. Pay close attention to what secures the loan and what happens if a payment is missed. It is a handshake with paper behind it.

The whole of it

What it is

I once watched a retiring baker sell her shop to the young man who had worked the early shift for six years. She did not want a stranger's bank to decide his fate. So she took part of the price in cash and the rest in monthly payments. That is seller financing in a small kitchen.

In plain terms, the seller of a business agrees to be paid some of the price later. The buyer signs a promissory note, which is a written promise to repay a set amount on set dates with interest. The seller is now both owner and lender. You will sometimes hear the term seller note or owner financing. They mean about the same thing.

Why would anyone do this? A buyer often cannot borrow the full price from a bank. A seller may want the sale to close, or may like the steady income. Sometimes the seller also believes in the buyer. The arrangement is common enough that the U.S. Small Business Administration describes seller financing as one piece that can sit inside a larger deal, and it publishes rules about how a seller note counts when an SBA backed loan is part of the purchase.

How it works

If you are holding an offer sheet right now, picture the price split into slices. One slice is the buyer's own cash, called the down payment. Another slice may come from a bank. The last slice is the seller note. The buyer pays the seller each month, or each quarter, until the note is gone.

The note carries a few terms worth knowing by name. The principal is the amount borrowed. The interest rate is the cost of borrowing it. The term is how long the buyer has to repay. A balloon payment is a large lump sum due at the end, after smaller payments along the way. Some notes are amortizing, which means each payment covers both interest and a bit of principal, so the balance shrinks steadily.

Security matters most. A note can be secured, meaning the seller holds a claim on something if the buyer stops paying. That might be the business assets, the equipment, or the shares. A note can also be unsecured, which leaves the seller with only a promise. The seller must usually file a form to make a claim on business assets official, and the paperwork differs by state. The Uniform Commercial Code, adopted in some form by every state, sets the framework for claims on business property, so a lawyer in the buyer's state should handle it.

Another term is standby. If a bank is also lending, the bank may require the seller note to stand by. That means the seller cannot be paid until the bank is paid, or cannot be paid for a set period. The bank has to agree to the structure, so ask early.

There is also something called an earn out. Here part of the price depends on how the business performs after the sale. It is a cousin of seller financing, not the same thing, and the contract has to define the measure very clearly.

The numbers, and where to find yours

Plenty of buyers ask what a fair rate is. I cannot hand you one, because no law sets it for private business sales. What the seller and buyer agree to becomes the rate, within the limits of state law. Many states cap interest through usury laws, so the cap in the buyer's state should be checked. The seller must also report the interest received as income, and the buyer may be able to deduct it. A tax professional can confirm how that works for your deal.

The IRS has a rule worth knowing. When a note carries too little interest, the IRS can treat part of the principal as interest anyway. The yearly minimum rates are published as the Applicable Federal Rates, and the current figure is the current figure, which the official source publishes each year. You can find it on the IRS website, which posts a new table each month. If you are the seller, this rate is a useful floor to compare against.

The Small Business Administration also sets rules when its loan programs are involved. The share of the price that a seller note may cover, and any required standby period, are set by the SBA's own program rules, which are published in its Standard Operating Procedure. The percent that applies is the current figure, which the official source publishes each year. The effective date of that rule is shown with the figure.

Two items live in your own paperwork. The first is the purchase price in the sale agreement. The second is the payment schedule in the note. Everything else grows from those two.

A worked example

Let me tell you about a woman named Dolores. She is buying a small print shop for $200,000. She has saved $50,000 for the down payment. A bank agrees to lend her $100,000. That leaves $200,000 minus $50,000 minus $100,000, which is $50,000 still unpaid.

The seller, a man named Walter, agrees to carry that $50,000 as a note. They set the rate at 6 percent a year, with payments over 5 years, or 60 months. A standard payment formula gives a monthly payment of about $967. Walter will collect 60 payments of $967, which is $58,020 in all.

Now check the cost. Total paid is $58,020. The original loan was $50,000. So the cost of borrowing is $58,020 minus $50,000, which is $8,020 in interest.

Walter benefits in a quiet way. He gets $8,020 he would not have received in a cash sale. He may also spread his taxable gain over several years, since he receives the money over time. That treatment is called the installment method, and the IRS explains it in Publication 537. Dolores benefits too. She closes the deal without borrowing the full amount from a bank.

Notice the risk on both sides. If the shop slows down, Dolores still owes $967 each month. If she stops paying, Walter may have to take the business back, and a shop he has not run in years may be worth less than he remembers. Hard truth.

Where it goes wrong

I have seen good deals sour over a missing page. The most common trouble is a vague note. If the paper does not say what counts as a default, or how long the buyer has to fix a late payment, the two sides will argue later. Spell it out.

Another trouble is the seller who stays too involved. When the seller is still owed money, he may feel entitled to a voice in every decision. A clear agreement about roles, in writing, protects the friendship.

The buyer also faces a danger. A business can lose value after the sale, yet the note does not shrink. The buyer has to repay the full amount whatever happens to the shop. That is why buyers sometimes ask for a right to offset, which lets them reduce payments if the seller broke a promise made in the sale agreement. It must be written into the contract to count.

Then there is the bank. If a lender is also involved, its loan papers may forbid the seller note from being paid early, or may demand a standby. A buyer who learns this after signing is in a bind. Ask the bank first.

Taxes can bite quietly. The seller owes tax on interest as it arrives, and may owe tax on gain in the year of sale depending on how the deal is built. The buyer's deduction for interest depends on how the business is set up. An accountant earns the fee here.

Last, a note that is secured only on paper is worth less than it looks. If the seller never files the right form, another creditor could get ahead of him. Filing is cheap. Skipping it is costly.

Questions to answer before you leave this page

Have you asked what share of the price the seller is willing to carry, and for how long? Do you know whether a bank or the SBA is also in the deal, and what that lender requires of the seller note? What will secure the note, and has the proper form been filed in your state? What does the note say counts as a default, and how many days does the buyer get to cure a late payment? Does the interest rate meet the IRS minimum, and does it fall under your state's cap? Who will advise each side, and have a lawyer and an accountant both read the papers? And if the business slows down next year, can the buyer still make every payment, and what would the seller do then?