This setup is known variously as owner financing, taking back paper, seller take-back financing, seller carry-back financing, or simply seller financing.
“I’d never heard of seller financing,” Passy said. “But the buyer said they were getting an SBA loan and this was how it had to be structured.”
What is seller financing in a business sale?
Popular in real estate, seller financing is also a fairly common way to finance a small-business sale.
In essence, the seller directly loans the buyer some of the funds needed to buy their business, eliminating the bank as middleman in the transaction. The seller then collects repayment in monthly installments, sometimes with interest, until the loan is paid off.
Benefits of seller financing when selling your business
Seller financing has pros and cons for the seller. On the plus side, there can be tax advantages to spreading out the timeframe for receiving the business-sale proceeds. A buyer might agree to a higher overall price if it can be paid back over time. And sellers can often charge substantial interest rates on such a loan, allowing you to make additional income from your sale.
How much interest can you charge? To figure your rate, start by looking at market rates for loans with the level of risk you’re taking on, said Holly Magister, founder of the seller’s resource platform ExitPromise. Magister is also a CPA and Certified Financial Planner.
For example, in mid-2023, CDs yield 5.25% and business loans cost about 7%. However, according to Magister, sellers are asking 8% to 9% to finance buyers due to the risk involved. She urges a careful assessment of risk and reward in such scenarios. “If the buyer has a very poor credit rating, I’d consider not doing it,” she said.
Another pro is that this arrangement might open doors to sell the business to a buyer who otherwise might not be able to afford it. If you care a lot about who you sell your business to, this might give you additional options.
Sometimes sellers go into a sale hoping to avoid seller financing, but can’t generate any other types of offers. This could happen for various reasons, including state of the market, the industry you business is in, or types of buyers who might want to buy that business. In those cases, being open to seller financing might be the only route to a sale.
The downsides of agreeing to seller financing, however, can be significant. You’ll likely take home less cash at closing, which means you have less cash to live on or invest immediately.
This back-back arrangement is also risky. Your buyer could also fail to make their payments over time, leaving you with less payout for selling your business. That risk is why interest rates for seller-finance loans are often high.
Think like a banker if you offer seller financing
If you’re contemplating accepting a sale offer that includes seller financing, Magister advises a cautious approach. You’re essentially playing banker here, so it pays to think like a banker.
Take a dispassionate look at your buyer’s creditworthiness. Who are they, what’s their track record, and do you feel confident they’ll make their payments? Sellers should vet a buyer carefully before agreeing to finance even part of the sale, Magister said.
“I recommend starting with a credit check on the buyer,” she said, “because there’s a reason they’re not going to a bank to borrow the money.”
That reason could be a poor credit rating that would have them paying sky-high interest rates on a bank loan. Or they simply might not want to lay out all the cash needed to close the deal, preferring to use leverage and keep some of their money for other investments.
On one deal where Magister advised, when the seller requested a credit check to set up a seller-financed loan, the buyer changed gears and made an all-cash offer. It turned out this buyer didn’t want the seller to learn how wealthy they were, as that might spur the seller to ask for more money.
“They were just hoping to get a sweeter deal and use less cash,” Magister said.
How to structure a seller financing deal
If your buyer’s credit report is favorable and you want to move forward, have a formal loan document drawn up that’s separate from the sale agreement, Magister said. This loan agreement is sometimes called a seller’s note.
All the terms of the seller financing loan should be spelled out, so there’s clarity on how long the term is, the interest rate you’ll charge, and what the minimum monthly payments are. You should define what happens if payments are late, too, Magister said. That includes how many days’ grace they have, when fees are triggered, and what you’ll charge.
You should also file a UCC-1 form with your state to register the debt, she added. That makes the loan public knowledge, so anyone else the buyer tries to borrow from during your loan term can see your loan is already in place.
In addition, Magister said someone on the buyer team should sign a personal guarantee for the loan. You don’t want to rely on the business’s profits to pay back the loan, because you don’t know whether the new owners will succeed in operating your business.
Should you use seller financing for 100% of your sale? Magister is against it. It’s too much risk, as you could end up with little to nothing if the buyer stiffs you.
“They should have to put up a down payment,” she said.
Seller financing as a marketing tool
While Passy’s buyer suggested seller financing, some sellers offer to take back paper at the start to help generate buyer interest. That’s what serial entrepreneur Chelsea Clarke, who coaches other business owners through her platform HerPaperRoute, did when looking to sell a marketing-services agency in summer 2023 for just under $500,000.
While the deal did not end up going through, the details she was willing to share about how she structured it are useful for others looking for creative options.
“I actually put it out in the world right from the get-go,” Clarke said. “I let people know seller financing is an option. It was a way to get people excited to make an offer.”
In an unusual structure for a seller-financed deal, Clarke offered zero interest for the loan’s first two years. The intent was to motivate the new owner to excel in operating the business, in order to pay off the loan more quickly. She felt a high degree of trust with her buyer, she said. Additionally, an agreement permitting her to earn post-close affiliate commissions from the business made the deal appealing to her.
Her loan terms allowed the buyer to overpay beyond the minimum guaranteed monthly payments to accelerate the payoff. If the loan still has a balance at the end of year two, interest charges kick in.
“Usually, I just want a guaranteed monthly flat rate, something like $5,000 a month for two to three years,” she said.
How to protect your assets during a seller financing loan
If you’re doing seller financing, Clarke has a big tip for protecting yourself: Retain ownership of the business’s registered internet domains as collateral. That way, if the owner doesn’t make all their payments and is in default, you can easily take back control of your site.
“I’m keeping the domain on my register,” she said. “It’s good for the seller, because the buyer knows you’re in a partnership until it’s all paid off.”
After reviewing his buyer’s offer and its seller-financing component, podcast founder Passy decided to go for it. Knowing he has the predictable cash flow of the buyer’s monthly loan payments coming in gives him breathing room to study the marketplace before deciding on his next venture.
“I’m not sure what I’m going to do next,” he said, “so it’s good to have a nice monthly income coming in for a little while.”