Yes, times are tough and everyone knows that conventional small business loans are exceedingly difficult to obtain. Moreover, small business loans will continue to be difficult to obtain for the foreseeable future. In reality, this isn’t anything new or specific to the state of the current economy. The fact is that conventional business loans have always been hard to get. Since the beginning of time (well almost), conventional lenders only made loans to the most bankable small businesses. In other words, conventional lenders always have and always will limit their small business loans to:
- businesses with several years of verifiable, positive cash flow
- businesses with a lot of collateral, and
- businesses with strong management.
Today, conventional lenders have a hard time working with even the best qualified small businesses. So – what’s a buyer/seller/broker to do? Rely heavily on seller financing.
I know, seller financing has always been around as an optional piece of the deal making puzzle. Seller financing isn’t optional anymore. Buyers, sellers and brokers should either use seller financing right now or they should plan to do zero deals until the credit situation settles down. In other words, plan to stay out of the game for two, three or four years.
SELLER FINANCING HELPS EVERYONE
Simply stated – seller financing can get deals done. This is true for a lot of reasons. For instance, nobody has to go through the massive paperwork production required by conventional lenders. Of course, sellers and buyers need to perform some due diligence on one another. However, a seller financed loan is no where near as demanding as is a conventionally financed loan. So the deal gets done, the buyer gets financing and the seller gets cash flow from the loan.
HOW SELLER FINANCING WORKS
Sellers ordinarily do not want to hold on to a loan for a long time. This means that the seller financed loan should be designed with the goal of having the buyer refinance the loan with another lender (for purposes of this article, a conventional lender) two or three years after the seller financed loan is originated.
Before I get into refinancing, you still need to consider the basics of a seller financed loan. A typical seller financed loan involves the loan being paid pursuant to the terms of a confessed judgment promissory note backed by a security agreement. Confessed judgment simply means that if the buyer defaults on the note, then seller can promptly obtain a judgment in court without resorting to formal litigation. The security agreement is just a written agreement which lists the loan’s collateral. The collateral is usually the business as well as any other assets of the buyer such as the buyer’s house. The security agreement is then made a public record so that the world is put on notice that the seller has some rights in the collateral if the buyer tries to do something with the collateral during the life of the loan.
The exact terms of the note will change from deal to deal. However, it is safe to assume that the note should have realistic payments based on the business’ revenue history. Even though a seller usually has no intention of holding a loan for a long time, the loan has to be structured such that it has at least a ten year repayment schedule with a balloon payment required some time earlier, such as three years. In other words, the notes are usually amortized over a long period of time but are due in a relatively short time. For example, a $200,000.00 note amortized over ten years at nine percent interest with a balloon payment in three years results in $2,533.52 monthly payments of principal and interest. Then on the note’s third anniversary a balloon payment of $139,072.08 is due. In a nutshell, the buyer has thirty six months to find another lender.
Once the terms of the loan are negotiated then the buyer signs the note and gives it to the seller. Meanwhile, the buyer must be doing everything in anticipation of refinancing the note.
ADVANTAGES AND DISADVANTAGES
Like everything else in life, seller financing has advantages and disadvantages for all parties.
Some pros for the buyer:
- relatively easy to obtain credit
- repayment terms can get very creative
- seller is kept in the game and still has an interest in seeing the business thrive
- depending on the terms of the loan, buyer can withhold re-payment if there is something wrong with the business
Some cons for the buyer:
- interest rates will probably be relatively high
- loans tend to be short term with an emphasis on refinancing as soon as possible
- seller might be constantly looking over your shoulder
Some pros for the seller:
- recurring monthly revenue for as long as seller holds the note
- will most likely obtain interest at a higher rate than anything else in your portfolio
- if the buyer defaults, seller can take the business back
- taxes can be spread out over the life of the note (don’t take my word for it, please consult your accountant for expert tax advice)
Some cons for the seller:
- seller is still closely connected to the businesses
- buyer could default
- seller has to wait to get all of the money
Small business finance is challenging in good economies and bad economies. OK, so things are a little difficult right now. People still want to buy and sell small businesses. Banks and other conventional lenders flatly do not have the ability to finance many small business deals these days. A good way to get around this is to do some significant seller financing, or else you will probably have to stay on the sidelines until who knows when.