Almost without exception, all business sellers would prefer to get 100% of their selling price in cash at closing – and for some very good reasons. Most sellers have heard horror stories about other sellers who sold their business for little or no cash down, and carried a seller’s note for almost the entire purchase price, and lived to regret it.
Nonetheless, I generally coach my selling clients that they should be prepared to take back a least a small seller’s note – perhaps for only 10% of the selling price – if the deal justifies it and the buyer is trustworthy and creditworthy.
Often when the seller insists on getting 100% cash at closing, the buyer, his banker and other advisors, begin to suspect that perhaps the seller knows something is about to go wrong with the business, and is eager to get as far away as possible. This suspicion obviously has a chilling effect on the negotiations.
In contrast, when the seller is willing to carry even a small seller’s note, say 10% of the purchase price, the bank is more comfortable, and the buyer and his advisors are more confident that they are not buying a distressed business, and also that the seller will be willing to assist with advice and counsel beyond the typical four week training period, should it be necessary.
One study focused on the impact zero seller financing has on selling price, and concluded that businesses which sold with zero seller financing sold for as much as 40% to 60% less than comparable businesses.
Other studies have shown that 70% of all business sales included some element of seller financing. This percentage no doubt increases during economic downturns and at other times due to the tightening of the credit markets.
This is particularly true of smaller businesses. One study concluded that in over half of all businesses sold, the seller financed over 50% of the selling price. Some businesses which are particularly difficult to “bank,” such as construction contractors, may be almost unsalable without significant seller financing.
Another benefit of taking even a small seller’s note and treating the transaction as an installment sale for tax purposes is that it may reduce – or at least defer – the seller’s total tax burden.
What should the interest rate be on a Seller’s Note? Most buyers initially propose an interest rate of 5% – 6% figuring this is much more than the seller could get from a CD if he invested the same amount of money with a bank. My own view is that a Seller’s Note is really subordinated debt, and therefore should bear an interest rate comparable to mezzanine debt to reflect the higher risk. I usually suggest that the seller offer to care a small seller’s note for an interest rate of not less than 10%, with no prepayment penalty. This way, the buyer has an appropriate financial incentive to pay off the seller’s note as quickly as possible, while the seller earns an attractive but fair rate of interest for the time his money is actually needed to close the deal.
One last thing to keep in mind regarding Seller’s Notes is that if the buyer is financing this acquisition with an SBA guaranteed loan – and perhaps even with conventional loan, the lender is likely to require that the Seller’s Note be on full standby. i.e., no principal or interest payments may be made on the seller’s note until the buyer demonstrates that he in not missing any payments on the senior debt. After 2-3 years, the senior lender may allow interest only payments, before lifting all restrictions and allowing principal and interest payments on the seller’s note. Again, if the buyer is trustworthy and creditworthy, and if the seller’s note has an appropriate rate of interest, the buyer has a sufficient financial incentive to pay off the seller’s note as quickly as possible, while the seller earns an attractive but fair rate of interest for the time his money is actually needed to close the deal.
If you would like to receive a copy of our white paper entitled: Value Drivers to Maximize the Value/ Selling Price of Your Business, please contact me directly.
As ever, if you know of a business owner who’s thinking of selling or buying a business and who might benefit from a free, confidential, consultation with us, have them contact me.
Mike Ertel, CBI, M&AMI, CM&AA
Managing Director, Broker
©2022 J. Michael Ertel PA