From Business Owner to Amateur Lender: What to Consider Before Agreeing to Seller Financing
The lifeblood of M&A transactions is capital, and we have been fortunate enough to have recently gone through a prolonged period (over the past 10 or so years), where capital has been readily available to buyers—and cheap by historical measures. Unfortunately for us in the M&A world, during the second half of 2022 it became clear that capital was becoming substantially more expensive through the ever-increasing interest rates. It was also becoming more scarce, as commercial lenders tightened their credit underwriting and became more conservative in their lending practices.
When debt capital is cheap and readily accessible to potential buyers, selling a business should be a straight-forward proposition of bringing the business to the market and waiting for the best offer to come in from the relatively large pool of qualified buyers. Under the current market conditions, selling a business may come with additional challenges for the seller. Sellers need to consider if they should offer financing to increase the number of potential buyers and increase the sale price for their business. In the past few months, we have seen a trend of more and more sellers agreeing to provide significant seller financing to get their transaction done and maximize price. It is a trend we expect to continue, but one that has pitfalls for the unwary or inexperienced.
What is Seller Financing? Seller financing occurs when the seller agrees to accept a promissory note from the buyer in lieu of cash for some portion of the purchase price. In short, the seller goes from being a business owner to becoming a lender. Often seller financing is used as a supplement to traditional bank financing in order to bridge the gap between what the bank is willing to lend, what the buyer is willing or able to pay in cash and what the value of the business is as reflected in the sale price.
Think Like a Lender: Before agreeing to seller financing, the seller needs to think like a lender. This is not always easy for the typical small business owner with an entrepreneurial spirit that may make them naturally less risk adverse than a stereotypical banker. Sellers need to do their diligence and satisfy themselves of the creditworthiness of the buyer. This often includes taking the steps that a traditional lender would take including running credit checks, verifying that the buyer has no liens, bankruptcy history, judgements or lawsuits hanging over it, reviewing the buyer’s personal and business financial statements, identifying collateral, considering how much down payment is prudent, and determining the buyer’s likely ability to refinance out the seller note at maturity if it is not fully amortizing. Finally, and maybe most importantly, does the seller have confidence that this buyer will have success taking over the business? If the business struggles under the buyer’s ownership, the seller might have trouble with collecting on its payments.
Consider the Tax Consequences: Seller financing may have the added benefit of allowing the seller to spread out the tax gains on the sale over a number of tax years via installment sale tax treatment, which aside from potential deferral benefits, in some cases may lower the applicable tax rate. However, it is very important to note that any ordinary income related to depreciation recapture will need to be recognized in the year the sale occurs, regardless of the cash paid to the seller in that year. If the assets being sold are considerably depreciated, the seller may find itself in a position where it has sold its business and instead of experiencing a cash windfall, ends up in a negative cash position after paying taxes generated by the sale and any existing indebtedness on the business.
Weigh the Risk: The decision on whether to agree to seller financing comes down to weighing the benefits and risks of doing so. While every seller financing transaction is unique, here are a few high-level reminders that sellers should consider as they weigh their options:
- Does the seller financing result in some tangible benefit that would not be available without it, which may be (i) a higher purchase price, (ii) more certainty of closing or (iii) more seller control on the timing of the closing?
- Before agreeing to seller financing, the seller should have its tax advisor run a full analysis of the tax consequences of installment sale treatment and net cash expected to be generated after taxes. Further, determine strategies for minimizing ordinary income that needs to be recognized the year of closing.
- Seller financing becomes necessary when traditional lenders are unwilling to make the loan. As a seller, why are you willing to make the loan to the buyer when the bank is not?
- Is the seller comfortable having a continuing relationship with the buyer for at least the term of the seller financing loan?
- Is the seller note the only financing in place or is it just a piece of the financing and subordinate to a senior lender?
- How will the parties properly document the seller financing, including the filing of UCC liens and mortgages, if appliable, to fully protect the seller’s position as lender?
This article was published in Finance & Commerce M&A Monthly column.