How to Buy a Business with a Seller Note?

January 24, 2024

Adam Hoeksema

I think that buying a business with seller financing is the best way you can buy a small business.  Especially if you are looking to buy a very small business valued at less than $1 million. Seller financing is one of the 5 key pillars that I wrote about here:

Read More: Buying a Business for Less than $1 Million 

I think seller financing can benefit both parties: sellers can potentially sell their business faster and often at a better price, while buyers gain access to financing that may be more flexible and negotiable than what banks offer.

What is Seller Financing in a Small Business?

A seller note is essentially a financial agreement where the seller of the business extends a loan to the buyer, who then repays this debt over time, typically with interest.

Why use Seller Financing for a Small Business Acquisition?

I think there are several good reasons to consider using a seller note to buy a business.

  1. Seller notes are faster - Securing an SBA loan to acquire a business can take a while.  Months and months.  With a seller note, a buyer and seller can come to an agreement on price and terms and close a deal within days or weeks, not months. 
  2. Avoid the business appraisal process - If the buyer is looking to use an SBA loan to buy a business and the SBA loan is greater than $250,000, the SBA will require the lender to order an independent business valuation or appraisal.  This will add several thousand dollars to the cost of the transaction plus it will probably take at least 10 days to complete.  There is also some risk that the appraisal comes back too low, and the SBA loan would need to be decreased.  
  3. The buyer might not qualify for a loan - the buyer might be the right person to buy the business, but might not qualify for a business loan based on personal credit or personal financial situation. 
  4. This business might not cash flow - In order to get a bank loan to buy a business, the business will need to show a history of being able to cash flow or pay that proposed loan from the profits of the business.  If you had a bad year last year for example, the deal won’t cash flow and won’t be able to get SBA approval.    

Of course there are some pros and cons of using seller financing.  

Pros of Buying a Business with a Seller's Note

Easier Qualification Process: Compared to traditional bank loans, the qualification process for a seller's note is usually less stringent. Sellers may not require as extensive a credit history or collateral, making it more accessible for some buyers.

Flexible Terms: Terms of a seller's note can often be negotiated to suit both parties. This flexibility can include the down payment, interest rate, repayment schedule, and loan duration.

Quicker Closing Process: Without the need for bank approvals, the process of closing the sale can be quicker and more straightforward.

Reduced Closing Costs: By avoiding some of the fees associated with bank loans, such as origination fees, buyers may save on closing costs.

Seller's Confidence in the Business: A seller willing to finance the purchase often indicates their confidence in the business's viability and profitability.

Opportunity for Mentorship: In some cases, sellers may remain involved in the business for a transitional period, offering valuable insights and mentorship to the new owner.

Cons of Buying a Business with a Seller's Note

Higher Interest Rates: Sellers may charge higher interest rates compared to traditional loans to compensate for the risk they are taking.

Potential for Overvaluation: Without thorough due diligence, or a quality of earnings report, there's a risk of overpaying for the business, especially if the seller is financing a significant portion of the sale price.

Risk of Seller's Financial Instability: If the seller faces financial troubles post-sale, they might push for early repayment or enforce strict terms, which can be challenging for the buyer.

Limited Availability: Not all sellers are willing or able to offer seller financing, limiting the pool of available businesses for purchase through this method.

Potential Legal and Financial Complications: The agreement complexities might require legal and financial consultation, adding to the costs and the need for expertise.  However, I would propose that the costs of closing a traditional bank loan would likely be higher. 

Repayment Pressure: Unlike some bank loans, where there might be options for deferment or restructuring, a seller's note might not offer such flexibility, especially if the seller is reliant on the repayments for retirement or other needs.

Seller Note Refinancing

One approach that I have seen work well is to close a business acquisition deal with seller financing and then refinance the seller note in a year or two and get the seller fully paid off. 

This allows the initial deal to close quickly, but it also allows the seller to receive full payment relatively quickly.  Lenders may also like to see this because they get to observe the performance of the business post acquisition under the new buyer’s leadership.  If the business has performed well, the buyer may have more financing options than she would have had at the time of the initial acquisition. 

Reasons to Refinance a Seller Note

Lower Interest Rates: Traditional lenders might offer lower interest rates compared to a seller note, potentially saving a significant amount of money over time.

Extended Repayment Terms: Refinancing might allow for a longer repayment period, reducing the monthly payment burden.

Improved Loan Terms: Other loan terms, like balloon payments or covenants, might be more favorable with a traditional lender.

Release of Seller Ties: Refinancing releases the original seller from the loan, which can be beneficial if the relationship has become strained or if the seller needs the capital for other purposes.

Risks and Considerations

Qualification Hurdles: Traditional lenders have stricter lending criteria. Your business must demonstrate financial stability and growth potential.

Costs: Refinancing can involve various costs, including application fees, legal fees, and potentially prepayment penalties on the seller note.

Changing Debt Structure: While refinancing can bring benefits, it also changes the debt structure of your business, which might include securing the loan with business or personal assets.

Ultimately, I really like the approach of getting a deal closed with a down payment from the buyer and a seller note, and then looking to refinance that remaining seller note in a year or two.  If seller financing just isn’t an option for you, I would encourage you to consider an SBA loan.  This article is my deep dive into how to get an SBA loan to buy a business

About the Author

Adam is the Co-founder of ProjectionHub which helps entrepreneurs create financial projections for potential investors, lenders and internal business planning. Since 2012, over 50,000 entrepreneurs from around the world have used ProjectionHub to help create financial projections.

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