What you're agreeing to
You are acting as the bank for part of the price. The buyer puts cash down at closing and signs a promissory note for the rest. Payments on that note then come to you each month until the balance is paid in full.
There is nothing complicated about the arrangement itself. A bank would normally provide the portion of the price that the buyer cannot pay in cash at closing. With seller financing, you provide that portion instead and take a note as evidence of the debt. The note is a short document, but the terms that decide how well you are protected are all in it. Before you sign one, you should be able to point to each of the following in the document itself:
- How much the buyer owes you after the down payment.
- The interest rate on that balance.
- The monthly payment, and when the first one is due.
- The maturity date, when whatever is still owed comes due in full.
One point catches a lot of owners out and it is worth stating plainly. At closing the business becomes the buyer's property and your ownership of it ends there. What you hold afterwards is a creditor's claim that depends entirely on the note and the documents signed with it. You no longer have a say in how the place is run, and you cannot step back in simply because a payment is late.
How a seller note actually works
Start with the price both sides have agreed for the business. The buyer brings the down payment in cash and that money changes hands at closing in the usual way. Whatever part of the price remains unpaid after that becomes the amount of the seller note.
The interest rate is set in the note at signing and it does not change unless both sides later agree that it should. It is the price the buyer pays for spreading the cost over several years rather than paying you in full at closing.
The term tells you how long the buyer has to clear the balance in full. Five years is common in deals of this size, though shorter and longer terms are both seen in practice. The payment schedule may run over the same period as the term or it may run over a longer one.
Each monthly payment is calculated from three figures.
- The amount owed.
- The interest rate.
- The length of the payment schedule.
Part of every payment covers the interest due for that month and the remainder comes off the principal. As the principal falls over time, the interest portion of each payment falls with it.
Some notes are structured with a balloon payment at the end of the term. That happens when the payments have been spread over a longer period than the term itself, leaving a balance still owing when the note matures. The buyer then has to pay that balance in one sum or refinance it before the due date arrives.
Payments normally start within a month or so of closing. The first due date and every other date that matters should be stated in the signed note rather than left to a verbal understanding between you and the buyer.
Why sellers agree to it
Most owners who carry a note do so for a practical reason rather than because they set out to become a lender.
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More buyers can afford the deal.
Plenty of capable buyers can run a business well without having the full asking price sitting in a bank account. A seller note can bridge the difference between what they can pay at closing and the price you have agreed with them.
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It can support a better price.
A buyer paying over several years can often agree to a higher price than a buyer who has to find the whole amount at closing. That higher figure comes with a cost to you because you wait much longer for a large part of your money.
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Payments spread income over years.
Instead of receiving everything at closing, you receive a monthly payment over the life of the note. Interest is paid on top of the amount you financed, so the total you collect over the term is more than the note itself.
How those payments are taxed depends on your own circumstances and on how the sale was structured at closing. That is a question to take to your CPA before you agree to any terms.
A worked example
The figures below are rounded and are included only to show how the arithmetic works on a deal of this kind.
Illustrative example only
There is no balloon payment in this example, so the final payment is the same size as the ones before it.
The buyer pays $240K in cash at closing and you finance the remaining $960K through the note. Interest is charged at 8 percent and the note runs for five years with payments of about $19,500 a month.
Over the five years those payments return the $960K you financed and pay you roughly $208K in interest on top of it. By the end of the term the balance is cleared in full and the buyer owes you nothing further under the note.
Change the rate or the term on that note and the monthly payment changes with it. It is worth running the figures on any offer you receive rather than judging it from the headline price alone.
The protections that matter
A note on its own is only a written promise to pay someone at a later date. The protections written around it are what give that promise weight if something goes wrong further down the line.
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A real down payment.
The buyer should put a meaningful amount of their own cash into the deal at closing. A buyer with real cash at risk has a clear financial reason to keep the business trading and the payments current.
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A personal guarantee from the buyer.
Ask for the guarantee to be given by the buyer personally as well as by the company that is buying the business. Without a personal guarantee the debt can end up sitting inside a company that may have very little left in it if the business fails.
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The business assets standing behind the note.
The note should be secured against the assets of the business so that your claim is properly recorded in the closing documents. That security interest is what puts you in line ahead of unsecured creditors if the buyer defaults on the note.
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Paperwork drafted by your own attorney.
Have your own attorney draw up the note or go through the buyer's draft line by line before you sign anything. The cost is small compared with the amount at stake, and a note is the wrong document to take on trust from the other side.
The points above describe how these deals are usually documented in practice. They are general information only and they are not legal advice for your particular sale.
The honest risk
Once you have sold, you are a creditor of the business rather than its owner. Creditors do not decide how a business is run and they do not control how much cash is sitting in the account on payment day.
If the buyer trades well, the note will normally be paid without much involvement from you at all. If trading turns down, the payments are often one of the first things to slip, at which point you are relying on whatever protections were put into the documents at closing.
Getting money back after a default can take a long time and you may not recover the full amount that is owed to you. That is why the size of the down payment tells you a good deal about how much risk you are really carrying on a note.
The quality of the buyer matters more in the end than a point or two on the interest rate. A buyer you trust to run the business properly at a fair rate is a better prospect than a weaker buyer who offers you a higher one.
A note also means waiting years for money you could otherwise have had in your account at closing. Only agree to finance a buyer you would be comfortable handing the business to in the first place.
FAQ
Is seller financing common in small business sales?
It comes up in most small business sales. A seller note usually covers the part of the price that sits between what a bank will lend and what the buyer can pay in cash at closing.
Can I charge interest?
Yes, and you should expect to. You are waiting several years for money that could have been paid to you at closing, and the interest is what you are paid for that wait and for the risk that comes with it. The rate is agreed before closing and set out in the note itself.
What if the buyer stops paying?
What you can do next depends on what was written into the closing documents. A note with a personal guarantee and security over the business assets gives you something you can enforce through the courts if you need to. A note without those protections leaves you with a claim that can be slow and expensive to pursue.
Does RockHaven ask sellers to finance?
Sometimes, where the structure of a particular deal calls for it. When we do, the amount and the terms are set out in our offer in writing, so nothing about a note comes as a surprise at closing.