Understanding Seller Financing

Q: We are about to sell our small business. The buyer has given us an offer where he is asking us to take back a note to help finance the sale. Having never sold a business before, we're trying to understand our risks. What happens if he were to try to pull out before the loan is paid? What is an appropriate interest rate for the note? Do we have the right to get his credit record?

A: It is very common for the sale of a small business to include seller financing as part of the deal structure. Seller financing can accomplish several goals from a buyer's perspective. First of all, a buyer always faces the risk that the success of a privately held business is tied to the involvement of the shareholders. By having the seller finance a part of the purchase price, it can give the buyer additional confidence in the fact that the sellers believe that the business can thrive without them. Additionally, seller financing can oftentimes help a buyer pay more for the business than the price that would be offered if the deal were financed only through traditional financing sources, such as a bank.

With that in mind, it is important to remember that the purchase/sale of a business is a two-way street. Just as a buyer will conduct due diligence to determine the viability of the business, become comfortable with its financial and legal matters, and assess the opportunities for growth, a seller should be comfortable with the buyer as well-particularly if the offer includes deferred consideration such as a note. The seller should understand the buyer's business background, motivation for purchasing the business and financial qualifications.

Now, let me answer your questions in the order you asked them. Should the purchaser of your business default on the loan, you would be able to exercise whatever rights are defined in the default clause of your promissory note. In general, you would usually have the right to get the business back-which is not always the best scenario if the business is not performing well, but which is commonly the only recourse. If you are able to negotiate it, you may be able to obtain collateral in the form of the business's assets (such as equipment) or through a personal guarantee by the buyer (this is usually hard to get but worth a try). However, if the buyer is using the business's assets to get a bank loan, you will have to take a second position behind the bank. You should seek to protect yourself should a default occur, but also keep in mind that seller financing is often required for a reason-lack of bank financing, risks in the business, to bridge a value gap, etc. I would strongly suggest that you work with your mergers and acquisitions attorney and advisors for direction.

Regarding the interest rate for the note-it is usually difficult to charge an interest rate much over going business banking rates for the loan. You should use the interest rates currently paid by the business as a good gauge. As a buyer is generally utilizing seller financing as a "bridge" mechanism to help the seller attain a higher price, it is hard to substantiate a rate much higher than what they would pay to the bank.

In the course of your due diligence on the buyer, it is not out of line to ask for their credit record, particularly if the buyer is an individual. Personal credit records are available through several outside services, as long as you obtain the written permission of the individual. Many of these credit companies can be queried via the Internet. They will charge a fee that you can ask the buyer to cover. You may also ask for a financial reference from the buyer (their financial planner, CPA) as well as business references.

As you can see, seller financing can provide benefits for both parties. Bottom line: Both parties need to be comfortable with the other's ability to deliver what is promised.

Loraine MacDonald is director of advisory services at USBX, an investment banking firm specializing in the mergers and acquisitions of small to midsized businesses. She has been involved in the valuation and sale of privately-held businesses for over ten years. She can be reached at lmacdonald@usbx.comor at (310) 315-6700.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.