If you buy a business with seller financing the person whose business you're getting agrees to accept a promissory note for part of the payment.
While most people in the business for sale market know about this, they may not understand the importance or the method of structuring the purchase agreement so that it supports the objective of the seller-financing plan.
Three common examples of what the buyer should request when negotiating for seller financing are:
1. Seller in "standby" position: If the buyer plans to get a loan from a financial institution for some of the cash that will be needed to buy or to operate the business, the seller financing language in the sales agreement should state that the seller agrees to allow another lender or lenders to be in first position among creditors. The seller, in standby position, may be able to take over some of the assets of the business to recover any loss if the buyer defaults on either loan. But that's only after the institutional lender - such as a bank or financing company - has seized the assets necessary to be reimbursed for its loss. When negotiating the transaction, the buyer needs to get seller's agreement to take a "standby" position behind creditors furnishing cash for the purchase.
2. Seller financing with earn out provision: More and more business sales contracts include an earn out agreement as a way for the buyer and seller to achieve a transaction even if they disagree about what price is to be paid. Buyers encounter situations in which the seller sees the business improving and considers its value to be what it "will be" worth in the near future, while the buyer thinks the correct price to pay is the value of the business at the present time. The solution to this problem can be an earn-out agreement. It will allow for the price to be adjusted over the months or a few years following close of escrow, in step with improvement of the business. That improvement usually is based on some mutually-agreeable measurement such as gross sales or owner's earnings before deductions for interest and taxes paid and allowances for depreciation and amortization. Most often, any changes in price following close of escrow, are reflected in changes in the amount of the promissory note held by the seller. In other words, if the value of the business increases, the buyer's payments to the seller will go up by a prescribed amount. In this kind of transaction, the buyer should make certain that the earn-out description in the sales agreement, and any formulae to be used, are clearly explained in writing and acceptable by both parties.
3. Balloon payment to seller anticipated with buyer's plan to refinance original purchase loan or loans in months or a short period of years following close of escrow: Refinancing can be accomplished once a buyer has gained experience and can demonstrate a solid track record of running the business successfully. In some cases, the promise of a balloon payment to be made to seller is a workable compromise between a seller who wants an all cash deal and a buyer who wants traditional seller financing. Terms of the balloon payment should be clearly stated. Payment may, for example, be contingent on the buyer being able to obtain additional funds to pay off a purchase loan from a financial institution and/or provide the seller with the balloon payment. In some cases the refinancing will enable the buyer to retire a "bridge" loan taken as a temporary measure for the cash required to help fund the purchase or provide for operating capital needs.
Seller financing can take many forms as it is used for part of a buyer's business purchase financing strategy. Buyers are cautioned to plan ahead for the various situations with clear and detailed description of the seller financing agreement in the sales contract, so that it corresponds with the overall financing plan.
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