Getting a business sale closed probably means someone has to hold a note. Should it be you?
When it’s time to sell your business, you’re in for an education. Structuring the terms of a business sale can be complex and may require you (seller) to hold a note. Many people don’t realize that if the buyer is obtaining Small Business Administration (SBA) financing, the seller may be required by the bank to hold a seller note that is typically up to 10% of the purchase price. Why? It’s because the bank wants the seller to be invested in the deal as well – and in some cases and with some banks, it may be non-negotiable.
But what if the SBA isn’t involved? Should you offer to finance part of the deal for the buyer?
VR Business Broker, Tim Bellon weighs in, “At the basics of any transaction is a willing seller, willing buyer and the ability to pay. If the seller is willing to remove friction and finance at least some of the deal, it opens up the opportunity to attract more buyers and potentially set up a competitive bid situation.”
Bellon further lays out how to structure seller financing.
Find the right buyer
Being “the bank” for a buyer means you have to be selective. A good business broker will vet the buyer so that they won’t waste your time. Part of this due diligence process is pulling their credit report and making sure they have at least a 700 credit score or higher.
Demand proper capitalization
Providing seller financing usually means the buyer must put down at least 25% to 35% of the purchase price. If they can’t come up with the money, it should be a deal killer. Another option is to ask them to explore SBA financing.
File a UCC lien
A UCC lien on a business is a lien similar to a deed of trust on real estate. It will provide you with a recorded security interest in the assets you are selling. A buyer will not be able to get a bank loan on the business that will allow him to take his original down payment out of the company. It also keeps the buyer from selling the assets until the loan is paid off.
Secure additional collateral
If you are holding a note for the buyer, you have the right to ask for a trust deed on the buyer’s house. However, keep in mind that you may not be in the first position.
Set up automatic drafts
Your purchase contract should request that all loan payments be made by automatic bank debit. Both parties must sign a bank contract authorizing the bank to take money out of the buyer’s account and put it into yours. Bank debits get paid BEFORE ALL other company checks, including payroll or rent. If there are insufficient funds on the first day, you will have first shot at the funds deposited during the next two days. This will eliminate those dreaded calls from the buyer asking for another ten days grace on his loan payment because his rent is due.
Regular financial statement reviews
You should request (in the Asset Purchase Agreement) that the buyer is required to provide you with financial statements on the business regularly. As the seller, you will be in a good position to judge the performance of the business and know if there is a reason for concern. You can also review the balance sheet to be sure your collateral is being maintained at a sufficient level.
Because the seller is assuming more risk, they should also expect more reward. One reward is a higher selling price. On average, a seller can obtain as much as 9% or more for his business if he finances 70% of the transaction (per VR business brokers data).
Another benefit is tax deferral. The Internal Revenue Services will allow portions of the taxes due from the sale of a business to be deferred into the future by the installment sale method. Non-recapture gains from the sale of capital assets can be deferred until the note holder (seller) receives principal payments in the future. This allows a seller to be taxed in future years when his tax bracket is probably going to be much lower. If a seller were to receive $500,000 in profits in the year he sold his business, he will find himself in the very highest income tax bracket – as high as 41% state and federal combined. If he received $50,000 per year over the next ten years, his combined rate would be 20% to 30%. The difference in tax brackets can mean a savings of up to $100,000 in taxes on a $500,000 gain.
Additionally, a seller note generally can bear interest at a higher rate than can be found on most other types of investments. Since a buyer can expect to pay as much as prime plus 2% to 2.5% for an equivalent SBA loan, a seller note at prime plus 1% or prime plus 2% is a very attractive alternative. At today’s prime, a seller note can be priced at 8% to 9% interest. The seller is earning 8% to 9% on his note before he pays the taxes from the sale of the business.
Consider this example:, if a seller received a $500,000 note with 9% interest, his interest payments alone would be $45,000 in the first year. However, if the seller received $500,000 cash when he sold the business, he would end up with just $300,000 after taxes. He then “would then have to find an investment that would pay him 15% interest to earn the same $45,000.
Put together, a 9% higher selling price, reduced tax bracket, and a high rate of interest paid on a before-tax promissory note, all translate into tens of thousands to hundreds of thousands of dollars in the seller’s pocket. Is it with the added risk that comes with it? Only the seller can answer. Be sure to talk to a qualified business broker to better understand how these options relate specifically to your business.
About Tim Bellon:
Tim Bellon, Owner VR Business Brokers: Tim was born and raised in North Dakota, and after the culmination of a 21+ year career in the U.S. Army, he and his wife Beth retired in Apollo Beach, FL. He earned his Bachelor’s Degree in History and Political Science from Concordia College, and a Master’s of Science in Defense Analysis from the Naval Postgraduate School.
Tim joined the VR Business Sales Team in 2012 as the owner and managing broker of an office serving the greater Tampa Bay, FL. During this time, he has focused on helping business owners realize their goals through selling, buying, or growing businesses. He also assists individuals, and companies looking to expand, in the identification and acquisition of businesses.
Tim is community-oriented and is a proud member of the following organizations; International Business Brokers Association (IBBA), Business Brokers of Florida (BBF), SouthShore Chamber of Commerce, Commercial Finance Association (CFA), American Legion, Disabled American Veterans (DAV), and the Knights of Columbus. Tim can be reached via email at TBellon@VRSouthShore.com.