The Prudence of Avoiding Seller Financing for Business Sellers
When selling a business, one crucial aspect that sellers need to carefully consider is the method of payment they offer to potential buyers. Seller financing, where the seller provides a loan to the buyer to cover a portion or all of the purchase price, might seem like an attractive option at first glance. However, delving deeper into the matter reveals potential risks and drawbacks that can make this financing option less favorable for business sellers. In this article, we will explore the reasons why business sellers should exercise caution and consider alternatives to seller financing.
Increased Financial Risk
By offering seller financing, business sellers are effectively taking on the role of a lender. This means they are exposed to the financial risk of the buyer defaulting on the loan. While the intention of the buyer might be genuine, unforeseen circumstances such as business downturns, personal emergencies, or market shifts can result in the buyer being unable to fulfill their financial obligations. In such cases, the seller may find themselves in the arduous process of reclaiming the business or initiating legal actions to recover the outstanding balance.
Limited Access to Cash
Opting for seller financing ties up a substantial amount of the seller’s capital in the form of a loan. This can be problematic if the seller intends to invest in a new venture, retire, or make significant purchases with the proceeds from the sale. Having liquid cash allows sellers to explore new opportunities or handle unforeseen personal expenses with ease. By contrast, seller financing limits their financial flexibility, potentially hindering future financial plans.
Deferred Profits and Returns
Seller financing often entails receiving the sale proceeds in installments over an extended period, which can span several years. This delayed payment schedule means that sellers won’t receive the full proceeds of the sale upfront, reducing their ability to reinvest or benefit from the profits immediately. Moreover, sellers may have to wait for the full amount, making it challenging to capitalize on new ventures or investment opportunities that require immediate funding.
Time-Consuming Collection Process
Enforcing the terms of a seller-financed deal can be an arduous and time-consuming process. If the buyer defaults or encounters financial difficulties, sellers may have to engage in legal proceedings to reclaim their money. This not only results in added stress and time investment but also incurs additional legal expenses, further reducing the overall return on the business sale.
Impact on Future Business Success
When a seller finances the sale, they might be invested in the success of the buyer to ensure timely repayment of the loan. This entanglement can make it challenging for the new owner to run the business without constant interference from the previous owner. It may lead to disagreements and conflicts, negatively impacting the smooth operation and growth of the business.
Conclusion
While seller financing might appear appealing as a means of attracting potential buyers and closing a deal, business sellers should carefully evaluate the risks and drawbacks associated with this financing option. By avoiding seller financing, sellers can protect their financial interests, maintain flexibility, and reduce the administrative burden. Alternative methods of financing, such as seeking external financing or finding buyers who can secure a traditional business loan, can offer a more secure and advantageous solution for both parties involved. Ultimately, the objective is to ensure a smooth business transition that benefits the seller and allows the new owner to thrive independently.
Video Transcript
Why Should Business Sellers Avoid Seller Financing?
Imagine you are selling a business. There is one really important thing you are worried about, and that is getting paid. And there can be risks when you are doing seller financing. Risks that result in you not getting paid. What is seller financing? It is when you agree that you will accept payments over time from the buyer of your business.
The Risks of Seller Financing
So, for example, you are selling a business, and Mary comes along. Mary is going to buy your business. And let’s say you are selling your business for a million dollars. So you say, “Alright Mary. If you can come up with $100,000, I will finance the remaining $900,000.” So essentially, it is going to be a loan, kind of like a mortgage, but a loan to Mary, and Mary is going to repay that. So let’s say in this hypothetical that Mary gets all the shares right away. So she is 100% owner when she pays that $100,000. And then there is a promissory note, and that promissory note says, Mary, you need to pay the remaining $900,000 over, let’s say five years. And let’s say it is at a 5% interest rate or whatever the parties agree to.
Impact on Business Performance under New Ownership
What happens if Mary stops making those payments or what happens if she has buyer’s remorse and decides, you know what, the business isn’t as good as I thought it was, or what happens if Mary runs that business to the ground and now the business is worthless and Mary doesn’t have the money to keep making the payments? Unfortunately, that is a scenario that I have seen played out time and time again. In this scenario, often what happens is the buyer, we will call her Mary, buys the business. But then she makes a number of changes, believing those changes will help the business. But for whatever reason, the business does not do as well under Mary as it did under the seller. Maybe it is because the changes Mary made were not helpful. Maybe they actually hurt, maybe Mary decided to upgrade the technology within the company or make procedural changes or make human resource changes. So she fired some employees and brought in some new folks. All of these things are very common, but often they can result in a change in the profitability of the company. Mary believes they will improve the profitability. And if that is the case, we have no problems. But if the changes result in negative consequences to the company, Mary may not be able to continue making payments, but it might not just be that.
Mitigating Risks in Seller Financing
Maybe the reason the problems start in the company after Mary takes over is Mary doesn’t have the same personality or Mary doesn’t have the same relationships, or maybe there is something like COVID or some big circumstance totally outside of Mary’s control, whatever the reason is, it is often the case that when a person buys a business, the business doesn’t do as well as it did when it was run by the seller.
So are you, as a seller, willing to accept the risk that the buyer may not be able to pay you the amount that you have agreed to? That is often the risk with seller financing because if there are problems and the buyer can’t pay and let’s assume the company gets altered in a way that makes it less profitable, you now find yourself with a person who cannot afford to pay. They can file bankruptcy, and you find yourself with a business that is in shambles because it has gone through all the transition of going from under your management to a new buyer’s management and whatever changes have been implemented since that time. That might be the firing of key employees, changing technology, whatever.
Exploring Alternative Financing Options
So those are the reasons why seller financing can be very risky and why sellers should consider whether they want to accept that risk. But there are some ways to mitigate that risk. In other words, you can do seller financing in ways that avoid some of those problems.
One way is to hold on to some control, some sort of management or have management shifted gradually over time. That can actually work well, but it can be frustrating for the buyer because the buyer often wants to implement changes. And so often it makes sense for the potential buyer and seller to have a conversation about what this transition period looks like. The other reason that may not work well is the seller might say, “I want to be done with this thing. I want to retire. I want to move to another state, whatever the plans may be after running the business. Often a seller is selling because they are tired of running the business. And so they may not want to remain in management. They might say, “Hey, I am willing to accept the risk of losing control over management. There is another thing that sellers can do to protect themselves in seller financing scenarios. Rather than immediately transferring all ownership to the buyer, the seller can say, “I will transfer the shares upon final payment of the purchase price.” So, for example, if the seller receives $100,000 as an upfront payment, and then five years of payments, which include interest for the remaining $900,000 in the million-dollar purchase price, the shares and the full ownership will not transfer to the buyer until after five years. Now, buyers may not be happy about that because ultimately, it gives the owner, the seller, full control over the business and controlling that. But that is one protection that can be put in place.
Sometimes there is some sort of hybrid where a percentage of shares will transfer each year as the buyer timely makes payments.
Another alternative. This isn’t called seller financing, but if the business is doing well and it has financial reports and a history showing a profit, those reports can be presented to a bank, and then the bank can look at the creditworthiness of the business to determine whether to fund a large portion, let’s say 90% of the buyout. And this is often done through an SBA loan. So you get the SBA loan through a loan through your local bank, but the SBA backs that loan or guarantees that loan so that even if the buyer defaults on it, the bank isn’t out 100% of the money. The bank is only out of the portion of the money, and typically, the SBA will guarantee more than half of the loan. So that allows banks to offer larger loans than they would otherwise do at lower interest rates than they would otherwise do. So an SBA loan is a great option for buyers because they have a lower interest rate and they get all the shares right up front. An SBA loan is also a great option for sellers because they get their cash upfront.
Summary
As I started out answering this question, one of the biggest concerns for a business seller is, am I going to get paid? And so making sure that the seller gets paid is one of my top goals when representing a business seller. So, to recap here, why should business sellers avoid seller financing? Because there is a substantial risk they won’t get paid. But, in this video, I have talked about a number of ways that you can mitigate those risks, and if you are interested in additional information, you can take a look in the description below. We will post a link afterward where you can get additional information about factors to consider when deciding what is the best way for your business sale to be financed.
Conclusion
If you have other questions about things we have discussed or other legal topics or business topics topics of importance to entrepreneurs, CEOs, and leaders running companies, please feel free to add them into the comment section below. I will use those questions to generate ideas and topics for future Live Q&A sessions that you can watch right here.
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