Clients interested in selling an investment a property or a going business sometimes overlook the possibility of providing at least a portion of the financing in order to help the buyer “make the deal”. While seller-financing is sometimes not a good idea, there are many sound reasons for considering this option if you are interested in selling your business, your investment property or other valuable assets.
A prime reason sellers consider providing at least a portion of the financing to a buyer has to do with the unwillingness of commercial lenders to provide all of the financing. This is a common scenario when considering the sale of certain types of businesses, such as restaurants and bars, service businesses without substantial capital assets or equity, and businesses where the sale price leaves the buyer with little initial equity following the purchase. Obviously, a substantial cash down payment by the buyer can alleviate this concern, but by the same token, most buyers would prefer to hold back a fair amount of cash reserve when embarking on a new venture.
Seller-financing can also make good business and tax sense. Properly secured, seller-financing can yield a better return when compared to more traditional investments such as certificates of deposit, stocks and bonds and similar vehicles. Securing seller-financing with proper collateral is critical to minimizing the risk as compared to these “safer” but lower yielding investments.
From a tax standpoint, depending upon the structure, seller-financing may allow the partial deferral of the tax obligation on the sale through use of installment sale tax treatment under the Internal Revenue Code.
Let’s look at an example of a typical seller financed transaction to get a feel for this area:
Suppose you are trying to sell a small auto parts rebuilding business, including machinery used in the rebuilding process, real estate on which the business is operated, and related assets. You find a buyer at a good price who seeks commercial financing through traditional sources. In analyzing the loan, the buyer’s bank discovers the real estate on which the business is located may contain an underground storage tank with a potential environmental problem. The bank is also uncomfortable with the purchase price as it relates to the value of the operating assets of the business. This is a common scenario which could effectively prevent the lender from extending your buyer a loan commitment for the full purchase price you are seeking. This is where seller-financing can be crucial.
Commercial lenders will be much more willing to extend financing in a close case if the seller is willing to take some of the risk. A commercial lender will feel more secure advancing a substantial portion of the purchase price if the seller is willing to do likewise. This is how many good deals are consummated.
If the decision is made to employ seller-financing to facilitate a sale of business or property, the following aspects must be considered:
- What portion of the financing should be taken back by the seller? The answer to this question will depend upon the perceived risk of the transaction and the success or value of the business or asset being sold. The seller’s immediate cash need is also relevant.
- What security will be available to the seller? This can include a mortgage on real estate being sold, a security interest in business assets, a pledge of accounts receivable, personal guarantys by the principals of the buyer and similar forms of security.
- What financing terms are appropriate? Typically, seller-financing should yield a higher rate of return than commercial financing, often two or more percentage points higher depending upon the risk of the transaction.
- How long should seller-financing extend and how should it be amortized? The choices here are many, including straight amortization over a long period, or a short period of amortization with a substantial “balloon payment” in a few years.