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.
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. This can be very helpful to a small business owner and those who 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.
Holly Magister, CPA, CFP
Holly also founded ExitPromise.com and to date has answered more than 2,000 questions asked by business owners about starting, growing and selling a business.
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Hi,
We sold our business and have a seller’s note with a personal guarantee. Should we have the note recorded with the county recorder?
Hi Margaret,
One of the best ways to secure the buyer’s promissory note, when an installment sale is part of the deal, is to file a Uniform Commercial Code (UCC-1) form.
Banks and other lenders do this and so should a seller when they offer the buyer any form of seller financing.
All the best…
Hi Holly,
If the seller is lending me, the buyer, the money. I want the company I’m buying to them pay monthly payments to him for the loan. But the loan is to me, not the company. How do I make that work?
I really hope you can help me understand this. Thank you!
Hi Lee,
It’s typical for the seller to require the buyer to personally guaranteed the Note Payable. If this is the case, essentially the seller is lending the money owed on the Seller’s Note to the buyer.
Does this describe your situation Lee?
If so, please let me know. If not, please explain a bit more and I’ll offer an answer.
I’ve been negotiating with a buyer about selling my business and he’s proposing I accept part of the sales price as a seller note.
I am okay with this and feel confident that he’ll pay me back. What worries me is if something happens to him and his son takes over the business. I don’t really trust his son.
Do you have any suggestions to help me protect the money he will owe me for the business?
David,
I am a business broker advisor with Exit Promise and have represented business owners in several transactions that involved seller financing. First and foremost, you need an attorney with expertise in this area to draft a seller note that will minimize your risks. Several possibilities exist on how to structure a seller note to secure the note and give you adequate insurance coverage. Outside of the note itself, the best way to minimize the risk of seller financing is to maximize the down payment in the sale.
What happens if the buyer does not end up paying on the promised seller’s note?
Hi Jet – I’d recommend you seek professional counsel in that case.