I’ll start this article by saying that I’m generally against seller financing of the sale of a small business. Too much can go wrong, as I’ll set out below. Let’s define what I mean by “seller financing of the sale of a small business.”
A business owner of a small business wants to sell it so s/he can move on to the next project, or retire. S/he finds a buyer, often someone in a similar networking group, or a long-time employee. They set a price, then come to me to draft the paperwork, including a “promissory note” for the payments to be made by the purchaser for the sales price.
The seller may accept a small down-payment for the purchase, or it may be 100% financed. This means the owner/seller transfers ownership of the business to the buyer. Then over the course of several years the buyer will make periodic payments to the seller toward the purchase price. Yes, exactly like paying for a car purchase over time.
Pretty much every time I’ve seen this, the purchaser is relying on the income from the business to pay for its purchase. As a seller, would you rather have a promise to pay $150k, or $150k paid in hand? Think about that one long and hard.
Let’s do pros and cons of this method of seller financing of the sale of a small business:
CONS OF SELLER FINANCING OF THE SALE OF A SMALL BUSINESS
There are many implications of a buyer not being able to come up with money to purchase your business. First, if they do not have the money in-hand, it may be they don’t have the acumen to run a business or accumulate wealth. Don’t hand ownership of your business, and thus payments over time for it, to someone who has not demonstrated an ability to make your business successful enough to pay your for its purchase.
I helped with a transaction where my client sold a small food-service business for something like $30k, payments to be made over time. Of course, the buyer ruined the business and I don’t think made any payments. Prior to financing the sale, the seller failed to get even such basic information as net worth statements, old tax returns and, if you can believe it, the home address of the buyer. I advised him to take his lumps and walk away, because we didn’t even know where the buyer lived to serve a lawsuit on her.
Second, if this is the case, the person may also be relying on the revenue from the business for their own salary. Can a $50k business generate enough revenue to pay for the owner’s salary, and also cover the periodic payments? Guess who isn’t getting paid if the business has hard times.
Is the Business Viable Enough for Seller Financing?
Last, if the business is not viable enough whereby a purchaser for it cannot obtain a bank loan, it may not be viable enough in the long run to generate the revenue to make payments on the purchase note. Banks are pretty good at analyzing these things before they hand over purchase money loans. Especially here in Asheville, there are agencies that practically throw money at business owners. They, too, however, do feasibility analyses before handing over the money.
Along this line, banks are better able to judge the credit-worthiness of the purchaser. What’s in their financial history that they aren’t disclosing to you? Multiple bankruptcies? Charges of credit fraud? Huge credit card debt? Banks can find this out; you might not be able to.
Last, as noted, the very first payment that will be missed by a buyer is going to be the one to the seller. Vendors, landlord, owner salaries will always take precedence. Unscrupulous buyers know that often the cost of a lawsuit to sue them is not worth it for an unpaid buyer.
And if an unscrupulous buyer stops paying the seller when, let’s say, $15,000 is still owed, what is the seller going to do? Suing on that amount is very costly compared to the probable outcome. And if the buyer is not credit worthy or is asset-poor to start with, odds of getting paid go down over time. But in the meantime they “own” your business. It’s a tough row to hoe.
Short version, if it’s a good business to be purchased, and the buyer has wherewithal and good credit it should be good enough for a bank to lend money to the purchaser, or for them to make a lump-sum payment. Let the bank take the risk of non-payment, instead of the seller.
PROS
A seller of a small business may not be able to find a good purchaser. Maybe your business isn’t in great shape, or the economy is shut down for some reason. Maybe it just isn’t a great business. Banks tighten up money in hard times. If you’re ready to exit your business, you may take the only offer you get, regardless of the terms. Not exactly a “pro” but it’s one reason in favor of seller financing.
Another “pro”, if you’re selling to a family member or valued employee, you can help them get started in business for themself in a manner they might not otherwise be eligible. Also, you can keep a better eye on the business and help out to insure it stays successful so you get paid. With a non-related third party purchaser, they may resent you showing up the office. Thus you thus might not be able to keep an eye on the collateral for the financing, that is, the cash flow of the business.
The last “pro” is that seller financing of the sale of a small business can be quick, and transaction costs are low. Drafting an asset purchase agreement and a promissory note and maybe a security agreement in collateral does not have to be complex or expensive. The turnaround on this kind of transaction can be as quick as a few weeks, all things considered. This is compared to waiting months for a lender to obtain documentation for a loan, analyze it, then grant the money.
CONCLUSION
Make your own decision about seller financing of the sale of a small business, but I don’t like it for the foregoing reasons. Whether you’re buying or selling any sized business, call me to help with the transactional work.
For all your businesses legal needs, call me in all of Western North Carolina at (312) 671-6453
Email me at: palermo@palermolaw.com.
Be sure to check out my other blog posts HERE. Be sure to listen to my podcasts with Matt Mittan at BizRadio.US