Should you finance a buyer who is purchasing your business?

On the downside, if you allow the buyer to pay you off slowly over time, you’ll retain many of the risks that come from continued ownership of the business while giving up control of its management. In most cases, the buyer’s ability to make the payments will depend on the future success of the business, yet your buyer may know little about your company, your customers, or even your industry. The buyer can mismanage your company down to nothing very quickly, if you don’t keep an eye on him. If the buyer runs aground and stops making payments, your only real recourse may be to foreclose on the note and repossess the business, but that means you’ll have to find another buyer and start all over again.

On the upside, carrying back a note for some or all of the purchase price may be the only way to sell the business, since banks have fairly strict lending criteria for acquisition loans. Moreover, seller financing can provide a tax break for you if you qualify for installment sale treatment. For the buyer, seller financing can be a godsend because you’ll generally have more relaxed qualification standards and more lenient terms than a bank would have.

Mechanics of seller financing. The simplest way to provide seller financing is to have the buyer make a down payment (generally, you should insist on a down payment that’s as large as possible), with you carrying back a note or mortgage for the rest of the purchase price. The business itself, and/or the significant business assets, provides the primary collateral for the note. A lien on the property is filed with the secretary of state’s office, so the world at large knows that it exists. If the buyer defaults on the note, you’ll be the first in line to step back in and take over the business.

Aside from its simplicity, this type of deal can be very flexible — you can adjust the payment schedule, interest rate, loan period, or any other terms to reflect your needs and the buyer’s financial situation. For example, you can provide for a floating interest rate, or one that starts low but goes up gradually over time. Most seller financing will be for a relatively short term (say, five to seven years) but will be amortized over a much longer payment schedule, so that at the end of the loan term there’s still a large portion of principal remaining. The buyer will have to obtain outside financing to pay off the balance of the loan in a “balloon” payment at the end of the loan period. The idea is that at that point, the business will be on a solid footing and bank financing will be easier to find.

The buyer may have lined up a bank to do the primary financing on the deal, and may want you to take back subordinated debt for the remainder of the price, in a variation of a leveraged buy out (LBO). In that case, you are second in line if the buyer defaults on the primary loan. Obviously, this is not as desirable a position for you, and if you agree to it you should demand a higher interest rate. You should also think about continuing to maintain an equity position in the company, so that you have a voice (even if not the controlling voice) in the management of the company.

Protecting your interests. If you agree to finance part of the deal, you should try to get the buyer to provide more security for the loan, besides the business itself. For example, you might require the buyer to put up a personal residence as additional collateral (assuming there is significant equity in the home.) Some buyers have other commercial real estate, or investments that can provide more security. You can also require the seller to personally guarantee the loan, just as a commercial lender would. This can protect you if, as is often the case, the buyer finds that running the business is harder than it looks and is tempted to welsh on the deal. And, of course, you’ll want to thoroughly check out the buyer’s background, including credit record, management experience, personal assets, and character, just as the buyer will check you out during the due diligence phase of negotiations.

In order to further protect yourself, you should require the buyer to take out a life insurance policy with yourself as beneficiary, so that the loan will be paid off if the buyer meets an untimely demise. If the buyer will be actively working in the business, you might also consider getting disability insurance on the buyer, although sometimes this is prohibitively expensive. Your sales contract may also restrict the new owner’s sale of assets, acquisitions, and expansions until the note is paid off, and may specify that you get to see the quarterly financial statements so you can keep tabs on the business.

Instead of financing per se, particularly if you’re being asked to put up secondary financing to a bank’s acquisition loan, you might be able to have the buyer purchase an annuity contract for you, or purchase some zero-coupon bonds. These are sold at a deep discount off of their future value. With this approach, the buyer gets the benefit of a lower payment now, but you won’t be so dependent on his or her future success. This plan works best in the situation where you suspect that you have a well-qualified buyer who could actually pay cash for the business, but simply doesn’t want to tie up all his funds there.

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