Holly founded ExitPromise.com and has answered more than 3,000 questions asked by business owners about growing and selling a valuable business.She has also authored articles for FORBES and Intuit and been featured in podcasts for organizations such as the International Business Brokers Association.
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A seller’s note receivable is an alternative form of business capital.
This type of debt financing is often used in small business acquisitions, where the seller agrees to accept a portion of the purchase price in a series of deferred payments. This occurs when the business buyer does not have sufficient cash to cover the entire purchase price.
A seller note is designed to bridge the gap between the purchase price and the financeable asset base of the company being purchased.
SBA loans may permit the borrower to include some or all of the seller’s note when calculating the borrower’s capital contribution to the transaction. Doing so can be very helpful to a small business owner and those who may buy their business.
The use of a seller’s note receivable is also quite common when selling a business with challenging characteristics – including its small size, substantial customer concentration, additional growth capital needs, high capital intensity, cyclical nature, and unpredictable or seasonal revenue patterns.
When a seller note is used, the buyer will present the seller with a written note which defines the interest rate to be paid, amount owed, and other terms for repayment. Essentially, the seller is self-financing all or part of the transaction.
Seller’s notes are fairly common in small business transactions since attractive seller financing often translates into a higher selling price than an all-cash deal.
Seller Note Risk
Because seller notes are generally unsecured and may be subordinated to other forms of debt such as a bank loan or business line of credit, the seller’s note is inherently riskier and therefore commands a higher interest rate (typically between 6% and 10%).
The seller in possession of a seller’s note receivable must ensure that the interest rate is high enough to pay off the debt, especially in the event the business is unable to generate free cash flow or bears a high risk profile.
In certain situations, the buyer and seller may agree on initial deferred or interest-only payments followed by a balloon payment to reduce the cash flow pressure on the buyer during the transfer of ownership.
A seller may want to take other measures to protect their lending position by including certain protective covenants in the note receivable instrument such as:
- Retention of the deed or title to property in an Escrow account held by a third party until the note is paid in full
- Interest rate escalation rights if the buyer defaults on the payment terms
- Financial reporting rights to allow the seller to keep tabs on the business’ ability to make future payments
- Debt Service Coverage Ratios requirements, similar to those a traditional bank lender may impose on a borrower
Seller Note Benefits
Seller notes allow for increased flexibility, both in loan terms and rates when compared to a traditional lender.
Assuming the seller has confidence in the buyer, seller’s notes can be a useful tool for both parties. Not only does the use of a seller’s note allow buyers to justify a higher purchase price, but a seller’s note can also speed up the closing process since negotiating the terms of a seller’s note is much simpler than sourcing and negotiating mezzanine debt, another form of alternative capital.
Business Sale with Seller Financing
Seeking methods to eliminate or reduce risk to the seller if the note is not paid by new owners.
Thomas,
While it’s impossible to completely eliminate the risk of the seller not paying, there are several ways to mitigate or reduce it. First, work with an attorney to ensure the note is secured by the assets of the business and/or the borrower’s personal assets. Additionally, requiring a personal guarantee from the borrower can provide further security. It’s crucial to review the borrower’s creditworthiness by assessing their skill set to own and operate the business, their credit history, available collateral, and their income or potential income outside of the business. Also, ensuring you provide a smooth transition after selling the business will help reduce the risk that the borrower defaults.
Thomas: Your best bet to secure your interest in a seller’s note is collateral. Whether that’s hard assets of the business, a personal guarantee, or some other asset that you can lay legal claim to in case of a default will make it less likely that the buyer misses a payment or defaults on a loan.
Remember that a bank doesn’t care how you spend the money they loan you–they only care what they get if you don’t pay them back! It’s all about the Collateral.
We are negotiating a deal to see our restaurant. We have agreed on a selling price of $4.75 million. The buyers want to pay us $3.75 million and to hold an interest only note for $1 million at 6% interest for three years. My lawyer feels it is risky to wait three years to collect to $1 M payoff and wants to require annual payments. The buyers have agreed to paying us $100K at the end of year one and year two, that is the most they are willing to commit to. We are contemplating offering to drop the selling price to $4.5 M for an all cash deal. Do you believe this would be beneficial to us considering tax and legal expenses of doing the deal either way?
Hi L!
Congratulations on your offer to acquire your business!
It is risky to hold a note receivable for such a large amount of money. That said, your buyer is putting down nearly 80% of the purchase price. That’s a qualified buyer!
If you drop the price by $250K, you’d be eating up a lot of cash in the deal that could go to paying your some of your tax and legal expenses. I have no idea what your taxes will be on the deal, given what you’ve shared.
Here are a few thoughts…
Since it appears your buyer is qualified due to the fact they have cash, you may want to consider asking them to go to a commercial bank for the $1M cash they need to close the deal.
At worse, they will have to pay the bank the interest they’re proposing to pay you. They may need to get an SBA loan (guarantee) to get the deal done.
Either way, the bank will be the bad guy telling them they have to make monthly payments. Not you!
Good luck!
I am looking to acquire a business. The cost is $725000, I am putting 10% down and with a $50k sellers note with no interest. They are recommending $250k in working capital. Do you think that is a good deal on my part>
JJ:
I’m afraid that we cannot answer your question. You’ve asked for an opinion, but you’ve provided very, very little information. The numbers you provided don’t add up and are really meaningless in terms of whether or not the purchase is a good deal. If I tell you a car is going to cost $250 a month, is it a good deal? You have no idea what kind of car it is, how long you have to pay the $250 a month, or anything about the condition of the car. So, the short answer is—there’s no way to answer the question.
Sold business (plumbing, heating, AC) carrying the sale of business to buyers for 10 years. The note states it is between our SCorp and buyer, we are now wanting to dissolve SCorp. Can that note be transferred to person in charge of Corp? Small Corp. with 1 person holding 100% of stock. There are no other assets left in Corp nor any liabilities, just this note
Hi Linda,
The note held by your S Corp is an asset of the corporation and assets may be distributed in kind to its shareholders just like cash (another asset) would be distributed.
So, the answer is yes as long as the terms and conditions of the note do not prohibit doing so.
Before proceeding, review the note’s T&Cs with your attorney and ask your CPA what (if any) tax consequences there may be if you distribute the note to the remaining shareholder.
All the best…
Hello, I have a seller note from the sale of my tech company and was thinking of selling it. Is anyone aware of a marketplace of potential buyers?
Good Morning,
I am contemplating selling my business to a private equity firm. They are proposing a deal structure of 60% cash, 20 % seller’s note and 20% equity in new co. The note is a 3 yr interest only, payable quarterly, with principal payable upon 3rd year anniversary of sale date. My concern is that the not is subordinated to any bank or financial institution debt that they may take on. Does that mean that the note cannot be paid off until the bank debt is paid in full? There is an acceleration of the interest rate if the note is not paid off in the appointed time, however, is there a way to get some sort of security to protect my interests here. It will be a significant amount of money. At least 4 M. Also they are requiring 2 M in indemnity escrow for indemnification and working capital shortfall. What happens if I ask them to use the note as the security for the escrow account instead of funding the escrow with cash? Does that 2 m still earn interest at the rate it would if it was not being used that way? Thanks
Sandra:
As your question is specific to your situation and all of the terms are negotiable in regards to a sale, I would recommend that you consult an attorney first. From the accounting standpoint, there is nothing “routine” about how you structure an exit deal, and the terms of each component of this transaction should be examined closely by your attorney.
Good luck and success in your exit!
I recently sold my business. Included in the transaction is a $2 million 5 year forgivable, subordinated seller note. If the business grows at less than a 20% annual growth rate, the note is forgiven and the buyer owes nothing (this is the likely scenario). If the business grows more than 25% annually, the buyer must pay the entire $2 million. I’m now being told that the $2 million note should be included in the purchase price (and be subject to taxation). This seems wrong to me. I’d rather pay the tax (even if ordinary vs. capital gain) after the payment is due. What is the proper treatment?
Hi Ben,
The answer to your question depends on how your sale agreement was written.
If the deal was structured with a deferred installment payment of $2M and only payable under certain circumstances, then you’d pay the tax on the $2M if and only when you receive the money.
The sale under an earnout agreement (which is what I think was intended by how you described it) is normally set up so the seller only pays tax when the earnout payment is received.
If the purchase price included the deferred payment, the tax on it very well may be applicable to the full amount. Again, it really depends on how the purchase agreement was drafted.
Hope this helps a bit.
Hello,
We are an S-Corp and have two employees who have proposed (or threatened leaving) buying the company at $250k, about $100k less than what our Accountant values the company. They want the president to gift them each 20% non-voting shares (40% total) from July 2022 to July 2023 when they would assume full ownership, paying $50k per year for 5 years. If they default, they would transfer the full 100% ownership back to the President (no statement about who owns the debit). I have so many questions. But if we ‘gift’ them shares, does that affect what we should be valuing the business at? Obviously we need to talk to a lawyer about a contract but it seems we would still be incurring all the expenses and yet sharing any profit with them in that one year ‘gifting’ of shares. Am I off here? Any help on how to get a valuation on the company and recommendations on how to proceed would be appreciated. Thanks.
Marie:
This is a transactional question and would best be answered by your attorneys and financial advisors. The value of the company as a whole does not change when shares of stock are transferred from one person to another, however, the equity in the company will certainly change hands based upon the percentage of stock a specific stockholder has.
Thank you.
Hello,
I currently own an LLC and am operating under an assumed business name as well. I’m selling my company to another llc and am carrying paper on half of the sales price for 36 months. My question is what I should do about the assumed business name. Should I transfer that to the buyer or do I need to wait until the note is paid in full? Thanks!
Joe:
The name of the business is an asset, albeit an intangible one. Like everything else in your transaction, it is an asset that has value and the parties are free to negotiate the terms of the transfer of that asset. If you sell the business and keep the name, then I can guarantee one thing: In three years, the buyer will find the name you kept has absolutely NO value to him because he’s been operating the business without it for that long.