Seller Financing Explained: When the Seller Becomes the Lender

Why a seller would agree to wait

Because more buyers can afford the business. Few individual buyers have the full price in cash, and banks rarely lend all of it. A seller willing to carry part of the price widens the pool of buyers, and a wider pool tends to produce a better price.

The note also earns interest, which can make the total received larger than an all-cash sale at the same headline price. And in some tax systems, including the US, being paid over several years can spread the tax on the gain across those years under installment sale rules. Those rules are specific, so sellers confirm the treatment with a tax advisor before relying on it.

Why buyers want it

It reduces the cash and bank debt the buyer needs. It also sends a signal: a seller who's willing to be paid out of the business's future earnings is telling you they believe those earnings will continue. A seller who insists on all cash at closing is telling you something too.

Seller financing keeps the previous owner interested in a smooth handover. They're far more likely to answer the phone in month four when some of their money depends on the business doing well.

A seller note, worked through

A seller carries $135,000 of a business's price at 6% interest over five years. The buyer pays about $2,610 a month, and over the full term pays roughly $21,600 in interest.

Sometimes the payments are calculated as if the loan ran longer, with the remaining balance due in one lump sum at the end. Amortize the same $135,000 over ten years but make it due in five, and the monthly payment drops to about $1,499. After five years about $77,500 is still owed and comes due at once. That lump is a balloon payment, and the buyer needs a plan for it, usually refinancing, well before it arrives.

The terms that matter

The amount, rate and term set the payment. Past those, a few provisions decide how much protection each side really has.

Security gives the seller a claim on the business's assets if the buyer stops paying, much like collateral on a bank loan. A personal guarantee from the buyer extends that claim to their own assets.

If a bank is also lending, it will usually require the seller's note to rank behind its own loan, and it may require the seller to accept no payments at all for a period. That arrangement protects the bank, and it means the seller is the last in line if the business struggles.

Sellers also commonly ask for regular financial statements and for default provisions, so a missed payment or a breach of the bank loan gives them rights under their own note.

The seller is now a lender, so check the buyer like one

A seller who carries a note is betting part of the price on someone else running the business well. Banks check a borrower's credit, experience and cash before lending, and a seller has every reason to ask the same things: has the buyer run anything like this before, how much of their own money are they putting in, and what will they do in the first year?

The buyer's cash in the deal matters most. A buyer putting in a meaningful share of their own savings has something to lose if they walk away from the business. One who is financing nearly the entire price with other people's money is taking less risk than the seller is.

Price, rate and term trade against each other

The terms of a note are negotiated together with the headline price, and each can buy the other. A seller may accept a lower interest rate in exchange for a higher price, or a longer term in exchange for a larger down payment. A buyer who cares most about monthly cash flow might accept a slightly higher price to get a longer, cheaper note.

Work out what each combination means in total dollars and in monthly payments before agreeing to any of them. Two offers with the same headline price can be worth very different amounts to the seller once the note's terms are counted.

A seller note is not an earnout

The two often appear in the same deal and do different jobs. A seller note is a fixed debt: the buyer owes the amount whatever happens to the business. An earnout is a contingent payment that the seller receives only if the business hits agreed targets after the sale, such as a level of revenue.

Earnouts bridge a disagreement about what the business is worth. Notes bridge a shortage of cash. Mixing the two up leads to a nasty surprise for one side when results come in lower than hoped.

Key takeaways

• Seller financing lets the seller be paid part of the price over time, with interest, through a promissory note.
• It widens the pool of buyers who can afford the business and signals the seller's confidence in future earnings.
• A balloon structure lowers monthly payments and leaves a large lump due at the end that usually has to be refinanced.
• When a bank is involved, the seller's note usually ranks behind the bank loan, which makes security and guarantees more important to the seller.

Frequently asked questions

What interest rate is typical for seller financing?

It's negotiated. Sellers often set a rate near or somewhat below what a bank would charge, trading a slightly lower return for a faster sale and a higher price. The rate, term and security are usually negotiated together.

What happens if the buyer stops paying a seller note?

The seller can enforce the note, which may mean claiming the business assets it's secured by, pursuing a personal guarantee, or in some cases taking the business back. If a bank loan ranks ahead, the seller's recovery depends on what's left after the bank is repaid.

Is seller financing a red flag?

Usually the opposite. Many sellers of healthy businesses offer it to widen their pool of buyers. A seller who refuses to carry any of the price in a deal where it's customary is worth asking why.