Minimizing Risk of Seller-Financed Business Deals

What Is Seller-Financing?

Seller-financing is where a seller of a business accepts partial payment of the purchase price from a buyer in the form of a Promissory Note. The buyer pays the seller the balance of the Note after the closing via negotiable terms over a negotiable period of time.  Accepting seller-financing is inherently risky for the seller, since there is never a guaranty that the buyer will make good on the Note. Moreover, seller-financing adds higher transactional costs (such as lawyer fees) and more paperwork at closing for both parties to the deal. However, for many business deals – particularly in service industries where the owner has a crucial role in the business – buyers require seller-financing because it ties the seller to the success of the business, thus ensuring the seller’s cooperation with the buyer after the closing. Businesses which are not financeable by the buyer via external lending (backed by the Small Business Administration or SBA) also sell more quickly when offering some seller-financing.

Minimizing Risk

Business owners may insulate themselves to some extent from the risk of partially accepting seller-financing by acting like a bank and thoroughly vetting buyers, securing collateral with a UCC lien, and obtaining as high a down payment as possible. The down payment should typically be at least 50% of the total purchase price in order to ensure that the seller is paid an appropriate amount at closing and to ensure that the buyer has enough skin in the game to actually make good on the Note. Without a sufficient down payment of at least 50%, the buyer is more likely to walk away from the business (and their obligations under the Note) due to unforeseen problems after the closing. Accepting up to 50% of the purchase price in the form of a Note is still risky for the seller in the case of default, and as such most sellers require a higher overall purchase price in order to compensate them for this risk.

Interview Buyer Prior to Accepting Seller-Financing

An overlooked way of minimizing the risk to the seller of accepting seller-financing in a business deal is for the seller to interview the buyer themselves in order to learn about the buyer’s background, business experience, and specific skill-sets in relation to the business being sold. This discussion should take place prior to the seller accepting the buyer’s offer, and should be facilitated by the business broker. If the seller believes that the buyer lacks the knowledge, skills, and capabilities of running their business successfully, then they have the right to refuse seller-financing to the buyer. As a practical matter, the buyer is essentially asking the seller for a loan in order to partially fund the transaction, and as such the seller has every right to interview the buyer and to qualitatively screen their abilities and background.

Place UCC Lien on Business

  • As security against the Promissory Note, the seller of a business may place a Uniform Commercial Code (UCC) Lien against the assets (both tangible and intangible) of the business being sold.
  • This creates an enforceable lien against the business assets (now owned by the buyer via another corporate entity in most cases) after the closing.
  • A UCC lien secures the collateral – the assets of the business – until the Note is paid off by the buyer.
  • As a practical matter, a UCC Lien will prevent the buyer from selling the business to a third party or obtaining financing on the business assets without going through the lienholder (and extinguishing the lien by paying off the Note).
  • In the event that the buyer defaults on the Note, the seller may enforce the UCC Lien and essentially take the business assets back from the buyer.
  • A UCC lien minimizes risk for the seller, but few sellers want to re-take a business that may be almost worthless (other than salvageable physical equipment).
  • On the other hand, a UCC Lien is very useful from a seller’s perspective if the business is still functioning and profitable but when the buyer simply stops making payments on the Note.
  • In this case, a UCC Lien provides the seller with a practical way of re-taking the business from the buyer (and keeping previously paid money for the business). .
  • In addition to placing a UCC Lien against the buyer’s business, a seller may also ask the buyer to personally guaranty the performance of the Note.
  • This is fairly rare in business transactions, but it does provide the seller a way to access the buyer’s personal assets in case of default on the Promissory Note.
  • A business owner who accepts seller-financing should consult with an attorney in order to properly place a UCC Lien or otherwise secure their interests under the Promissory Note

Priority of Liens

For most business transactions involving external funding backed by the SBA, the bank requires the seller to still accept some seller-financing. The amount of seller-financing in such instances is normally around 10% of the overall purchase price. In such instances, the UCC Lien on behalf of the seller is subordinate (or below in priority) to the lien rights on behalf of the bank funding the transaction. For non-externally financed business deals, the seller (or their attorney) should still verify in what priority their UCC Lien will be in relation to any other lienholders placed against the buyer’s business assets. Sellers should place a UCC Lien against the business assets immediately after closing so as to secure their place in line of priority against other possible lienholders.

Offering seller-financing widens the pool of possible buyers by lowering the required funds a buyer needs to buy a business. Further, seller-financing ensures a buyer that the seller’s interests will be fully aligned with the buyer’s interests after the closing. The seller should be compensated for the risk and higher transactional costs associated with seller-financing through a higher overall purchase, and may minimize the risk of seller-financing by interviewing the buyer, requiring as high a down payment as possible, and securing their security interest via a UCC Lien against the buyer’s business assets or through a personal guaranty against the buyer’s personal assets.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.