Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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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.
My husband and I are purchasing an investment building from my grandma for $750,000. The bank is giving us a loan for $600,000 and we’re thinking about doing a seller’s note for the remaining $150,000. My grandma is not concerned about us making the payments. What are the steps involved in putting together a seller’s note? Are there legal guidelines or requirements? Does the seller get taxed less because she only received the $600,000 upfront? Are payments just reported at the end of the year when doing taxes?
Thank you
Hi Brittany,
When you state ‘my grandma is not concerned about us making the payments’, it leads me to believe she may be intending to gift these payments (loan) to you and your husband.
Doing so is possible and is a common estate planning strategy. That said, I know nothing at all about your grandma’s estate (size, intentions, need for cash, other heirs, etc.).
Your grandma, husband and you should consult with an estate planning attorney and your CPAs about your plans and their potential ramifications.
Setting up the seller’s note in your situation have estate and tax implications for your grandma and should not be a DIY project.
If your grandma is paid $600K this year, then she’ll be required to report the sale of her investment property this year. If subsequent payments are received by your grandma in the years to come, they she may be eligible for reporting the transaction as an installment sale where the subsequent payments are taxable to her as she received the payments.
Again, this is not a DIY project!
All the best to you, your husband and grandma!
Im seeking to buy the residential construction business I’m currently working for. The owner is approaching retirement in the next few years and we’re preparing to layout the structure for the agreement.
I have no capitol for a down payment and I’m hesitant to take money out of my home. The owner is helping me figure out a work around. We’re looking into one possibility for him to issue a note and the company to issue me shares each year. I in return, would then sell, and with the proceeds, I would write him a check each year until payed off. I would be liable for the taxes on the income from selling the stocks. What are your thoughts. Perhaps his note is to assist with covering the tax liabilities? Im confused and came across this site looking for information. At some point I will need to hire an attorney on my side to review the deal and advise.
Thanks in advance!
Hi Timothy,
It’s wise to seek advice before you and your employer strikes a deal. I absolutely agree.
However, doing so BEFORE the deal is reduced to a purchase agreement is best.
Using a Seller’s Note as the only form of capital to buy the business can be problematic for the buyer and the seller.
Happy to set up a call to discuss options for you and your employer before you go too far along.
Here’s where you may set up a call with me.
Our company is in talks with a physician practice, that is open to doing 100% seller financing, from a tax point view, how beneficial is this to the seller? Also, after a couple years of making payments, could we approach the SBA and obtain a long-term loan and pay the seller off completely? and how does this process work?
Thanks,
Zeeshan: If you are the buyer, the tax situation of the seller is an irrelevant piece of data, especially if there is already a clear benefit to you (100% financing!).
You could make application to the SBA or another lender at any time, including up-front, as long as there is no prepayment penalty on the seller’s note. The new lender will look to see what your “skin in the game” is, but most medical practices are pretty easy deals to do as long as the buyer doesn’t have a lot of other baggage.
Why would the buyers bank tell me that I need to have my lawyer prepare a sellers note?
Hi Heather,
If you are selling your business, you are best served to have an attorney draw up your purchase agreements, including a Seller’s Note. This will protect YOU!
And it’s worth every penny you pay to do so.
The buyer’s bank doesn’t want the deal to fail at any time and knows if you get legal counsel before you sell, everyone is more likely to have a good outcome.
All the best…
I sold my Allstate agency and didn’t take a personal guarantee as I was promised Termination payment. The note was for 7 years and I don’t want to wait that long anymore to get my money. Payments automatically get paid to me. How can I sell this loan?
Eve:
You could find an asset buyer that will give you a lump-sum in exchange for the payments. Of course, the buyer will give you a discount because they need a return on their investment, they have to also consider the time-value of money, and finally, the potential risk that the payer stops paying early.
One well-known buyer is JG Wentworth (i have no affiliation with that firm). I am certain there are many others.
We’re selling our business to one of our competitors who has been bugging us about selling for years. They just gave us their proposal and they want us to accept half of their offer with a note. Is this reasonable?
Hi Eric,
Seller notes are common in the sale of businesses. Many lenders will often insist on it when financing the purchase of a business.
Since you say they have been “bugging” you for years implies to me that they are very eager to buy your business, whereas you seem a bit indifferent, and not in a rush to sell.
As someone whose customers come to me after they’ve defaulted on a small business loan, I would be hesitant to accept a note for half the purchase price. If they don’t make payment on the note, it can be very difficult to collect, especially if they end up closing the business.
If I were in your situation, I’d push for more cash. If they want to purchase your business that badly, hopefully they be flexible. Remember, everything’s negotiable!
Alternatively, you could also encourage them to seek financing elsewhere. Whatever business you are in, I’m guessing its not a lending or financing business, so I’d encourage you to lay that risk of non-payment off to a lender if possible.
The other factors to keep in mind are the terms of the note. Here are some things to consider:
1) The term of the seller note (i.e. how long is the repayment period)
You want this to be as short as possible. 3-5 years is reasonable.
2) The interest rate. Commercial rates are always changing, but you could easily as a local small business lender what the rate might be for a loan like the one you are giving to the seller.
3) Collateral – You’ll want to secure the loan with the assets of the business. That way, if they default, you can take them back or sell them. If the business assets are not sufficient, you could also ask to take a lien on real estate owned by the buyer. Banks do this all the time….less common for seller notes.
4) Personal Guarantees – Even though the buyer may be a business entity, you’ll want to get personal guarantees from the owners of the business. The SBA requires anyone with more than a 20% ownership stake to guarantee their loans, as well as anyone who is crucial to the performance of the business (regardless of ownership %).
5) Seller cash flow – Lenders perform their own analysis to determine whether a borrower can repay the money they are borrowing. If you are going to hold a substantial note, you should be confident that they can pay you. The best way to do that is get at least 2 years of financial statements. If you aren’t familiar with financial statement analysis, you can ask your CPA to help you.
Overall, cash is king. Any other arrangement represents a very real risk of non-payment. As a seller, you goal should be to get as much cash upfront as possible!
Eric,
I am a Business Broker adviser with ExitPromise and have represented sellers in transactions with significant seller financing. The first question to ask the buyer is why do they want you to agree to 50% seller financing? It is not unreasonable to propose a high % of seller financing, but buyers typically propose this if they cannot get a bank or another third party to finance most of the transaction. If you consider this deal structure, you need to confirm the buyer is in a strong financial position and there is no risk they would default on the payments. Also, you need an attorney to write a note that protects you in every way possible.
In rare cases, a buyer will push for a high percentage of seller financing to insure that the seller will provide the necessary assistance through the transition of ownership. Or, they may ask to make future payments on the note contingent upon the seller meeting certain future obligations or the company achieving a minimal level of financial performance. If this is the case, is the buyer being reasonable to propose this deal structure? Or, is the buyer asking you to assume an unnecessary risk?
I hope this information is helpful.
Eric,
A buyer can make any offer!
As the seller you have the power to accept, reject, or counter; not just on price but also on terms.
Ultimately the percentage of seller financing a seller accepts is based on his or her confidence in their own business to make the money the buyer will be using to repay the note, their confidence in the buyer’s ability to run the business, and other offers available. To David’s point below, the Down Payment is really the only thing you are guaranteed!
What’s “reasonable” is subjective.
That being said, before I was a business broker I sold my business and took a 50% seller note. For me it made sense and it worked out.
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.