“Hey Walker, isn’t part of the appeal of buying small companies that I can use seller financing? Doesn’t this mean the seller basically becomes the lender for the business I’m buying?”
Yes… and no.
Although seller financing looks like a great deal on the surface, it has a number of nuances that you might be overlooking. Today, I’m going to share why I generally avoid seller financing, but I’ll also include the few situations when it might make sense to use it.
Here are six reasons why you should avoid seller financing:
1. SBA Is Better Than Seller Financing
If you’re deciding between the options of SBA financing and seller financing, go with SBA financing – hands down.
Originally, before the SBA loans of today you know and love, seller financing filled the gap when there was no way to get bank financing for these deals. Slowly, the SBA started to back acquisition loans, but you needed a lot of collateral, making these loans prohibitive for most buyers.
Then, at the start of 2018, the SBA eased the requirements for buyers, allowing US citizens or green card holders to acquire businesses with just a personal guarantee, without needing any collateral. In fact, the change was so revolutionary in democratizing business acquisitions, that the roll out of the new policy was what led me to finish writing and publishing Buy Then Build.
Buyers still think that a seller financed deal is preferable to an SBA financed deal, but that’s simply not true. If you can get SBA financing, go get it and call it a day.
2. Minimize Your Creditors
By taking on seller financing, you’re adding another party to whom you owe something.
Source: Universal Funding Corporation
When I’m working on a deal, I prefer not to owe anything to the seller—not money, not time, not anything. I want them fully paid out, and my goal is to have them completely out of the picture post-transaction. There’s going to be a transition period post-closing where they help with the business, but I want to extract as much value from that finite timeline then part ways.
However, if you owe that seller money, then they, on some level, have a right to show up at the office. They also have long-standing relationships with current employees of your business, which may create an avenue for unnecessary drama. It’s not how I want things to happen – this is just the reality if sellers continue to be involved after the sale.
You may feel like you have a higher tolerance for social dynamics and an ability to navigate these situations with ease, but if you’re looking to minimize risk and increase your bandwidth to completely focus on your business, I recommend getting the sellers out of the picture as soon as possible.
3. Deal Doesn’t Value or Has Poor Documentation
If you’re pursuing a deal that needs to rely on seller financing, this often indicates a problem with the business. It either gets a valuation from the SBA that doesn’t justify a full loan or the financial documentation might be so poor that the SBA won’t fund the deal. In either case, these are red flags that the business might not be as valuable as it looks on the surface.
Now, if the business simply has poor documentation that the SBA won’t accept, but you’re able to verify that the business has strong financials, you can leverage this and see if you can get a better deal by getting the price lowered, instead of opting to get seller financing for the full amount.
4. Personal Guarantee
If you have a mix of SBA loans and seller financing, more often than not, a personal guarantee will also be attached to the seller note, which can complicate matters if you default.
If there’s an SBA loan involved, you can seller finance a portion of the deal that the SBA may not, but the seller note piggybacks on the personal guarantee required by the SBA loan. In essence, the personal guarantee you sign would apply to both the SBA loan and the seller note.
Source: Fast Capital 360
That said, when a deal is structured with an SBA loan and seller financed, the seller note will always be subordinate to the SBA loan. That means, if you’re able to make payments toward the SBA loan but you can’t make payments toward the seller note, the seller won’t be able to take over the business since the bank is satisfied, but the seller can still make your financial life difficult. They won’t be able to foreclose on your business, but they can negatively impact your credit score.
If you find yourself in a position where you can only pay the bank but not the seller, which is not ideal and I hope you don’t find yourself in, you have to worry about dealing with two lenders instead of just one (to go back to my second point about minimizing creditors).
5. Price Is Lower if You Pay in Cash
The first time I was getting ready to sell one of my companies, I reached out to Gary, a seasoned broker I knew for years. Gary had been around brokering deals for decades, and I learned a lot from him over the years.
One day, we were discussing selling my business, and he said “Walker, I value your company. I can get you X dollars for it.” When I asked him if there was any way we could sell it for more, he shook his head as he responded, “Walker, listen. I can sell your business for a billion dollars, but the terms are a dollar a day for a billion days.”
Whenever you extend an amount of money over time, you have to pay more for it. However, if I give you cash at closing, I’m going to give you a smaller amount overall than if I’m paying you over time.
Source: The Balance
This may seem like a no brainer, but this fact is frequently glossed over. If you have the option to pay for a business in cash versus seller-financing the deal, it’s going to be the better option for many reasons, but one being that you’ll pay less in the long run.
6. The Buyer Isn’t the Main Beneficiary of a Seller Note
What I’m about to say is going to be very unpopular with lenders.
The real beneficiary of a seller note is not the seller. Maybe if they’re getting an extremely high price and taking advantage of the buyer. It’s not the buyer, either, because now you have two parties you owe money to instead of just one.
The real beneficiary is the bank.
How?
Lenders decide who they’re going to loan money to by determining the business’s debt service coverage ratio (DSCR). DSCR is the net operating income divided by the debt service.
Source: Investopedia
Ideally, banks are looking for 1.2 to 1.25 DSCR, anywhere north of that is universally believed to be a very strong and lendable business.
I’ll give you an example.
Let’s say your net operating income is $100,000. To come up with 1.25 DSCR, your debt service needs to be $80,000.
Again, based on how the math works, if the debt service is lower than $80,000, even better, as it creates more cushion between the income and the debt service, increasing the DSCR.
Now, if the lender is evaluating a business and decides that the margin between the net operating income and debt service is too slim, they’re going to want the deal to be structured in a way where the debt service is lowered to increase the DSCR.
Who’s negatively affected when the bank only agrees to lend at a fraction of the purchase price? The seller. The seller would have to come down in price in order to sell the business.
However, a seller note can reduce the DSCR of the business with the right terms.
When a bank calculates the DSCR, it’s only taking into consideration the debt that has to be repaid beginning upon closing. More often than not, buyers will choose to bridge the gap between the purchase price and what the bank is willing to lend through a seller note.
To help get debt service into compliance, the seller note will have standby terms placed on it or it will be interest-only. Standby means that the seller will not receive payment for a specific period of time (example: two year standby). This will remove it from the debt service considerations and can potentially allow it to be used toward your initial down payment as well, but that’s for a different article.
Seller Risk = Buyer Benefit?
Sometimes you’ll hear that seller financing minimizes risk for the buyer because the seller is still still invested in the business and won’t allow you to fail (the banks refer to this as seller’s risk).
There is some data from the SBA that suggests there’s an element of truth to that, but if the seller note is for 5-10%, which is common, it’s a relatively marginal amount of money compared to the lion’s share of the purchase price that’s covered by the SBA loan. Especially when that seller note has a two year payment deferment period and a term of ten years (in line with SBA requirements for additional seller notes), the seller will not be as invested in the success of the business simply to recoup the small amount that’s seller financed and spread out over ten years.
Like I said, the bank always wins and especially so when there’s a seller note.
When to Use a Seller Note
Now, there are specific scenarios where seller financing makes sense. Let me tell you five situations when you should consider using a seller note.
1. Deal Is Less Than $500,000
If the deal is less than $500,000, you may have no choice but to use seller financing. It’s difficult to get bank financing for smaller deals, but the deal may also be too large for you to pay for in all cash. If you want to buy a smaller business and the seller is amenable to providing a seller note, that may be the best route to simply get a deal done.
2. A Quick Transaction Is Required
I’ve mentioned the four D’s before – death, disability, divorce, or disagreement (debt can also be another one). These scenarios would precipitate a quick transaction, because if a seller is dealing with one of these situations, s/he needs to sell the business quickly to avoid the business shrinking.
Because time is of the essence, a seller won’t have the time to do weeks of due diligence and wait for bank financing to take place (which can take anywhere from 45-90 days). Seller financing allows the seller to find a buyer and get a deal done quickly.
3. No Personal Guarantee
Normally, if there’s a seller note in conjunction with SBA financing, the seller note will be secured by a personal guarantee. However, a seller can choose to offer a seller note that is unsecured because it gives them the flexibility to set different terms outside of the SBA’s requirements.
Source: Camino Financial
If you can get a seller note with no personal guarantee, where the collateral usually becomes the business itself, this can be a good option.
4. Non-SBA Eligible Business
There are a number of factors that would make a business non-SBA eligible. If it’s a foreign entity, it won’t qualify. If it has too little documentation or hasn’t been around for a long time, it likely won’t get SBA financing. Whatever the reason, if you don’t have SBA financing as an option, you may be limited on your options to finance a business and may need to rely on seller-financing. Whatever it takes to get a deal done (if that’s your goal), as long as you understand the risks of what you choose to take on.
5. Not Enough Cash
Very similar to our last point, if you don’t have enough money to put down on the deal, then you may have no choice but to use seller financing for this.
That said, if you don’t have any cash to put into a deal, that’s not a great starting point for any buyer. You’re going to waste a lot of people’s time, especially since the majority of buyers coming to the table have at least something to put down in any deal. The chances of you finding a 100% seller financed deal are very slim, and if you come across one, you want to be wary of why the seller is willing to completely finance the deal.
Seller Financing Is Overrated
I’ve bought eight companies over the years. In all my deals, I only used seller financing once, and I didn’t like it. It kept the seller too involved in the business, which affected the operation because they were emotionally and financially tied to the business’s performance.
While seller financing is seen as an option that provides flexibility for all parties, it introduces complexities that can outweigh the benefits. Whether you choose to include seller financing or not in your next deal, make sure you take the time to understand the financing structure and the implications on your business operations.
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