SELLER FINANCING – RISKS AND REWARDS
Mitigating the Risk of Seller Financing
Finding the Right Buyer. Finding a buyer is not easy, and, finding the right buyer is even harder. That is what your broker is trained to do. If you are going to be the bank for your buyer, then, act like a banker! During the Due Diligence process, the buyer is thoroughly inspecting your business. You should be thoroughly inspecting hi at the same time. Ask the buyer for a complete credit report. A detailed report is available on www.freecreditreport.com for less than $40, and, a less detailed one is free on www.annualcreditreport.com.
You should select a buyer whose FICO credit score is at least 700 and, preferably 750 or more. One cannot obtain these scores by accident. It takes years of hard work and careful budgeting. An individual with a high FICO score is a fighter. He has worked hard to stay current with his creditors. This is the type individual you want to consider playing the bank for!
Proper Capitalization. Make sure the buyer has at least a 25% down payment or more. If he doesn’t have that amount of equity to put into his new business, then ask him to get an SBA loan. If he defaults, the government can absorb the loss better than you. Do NOT conspire with your buyer to create an undercapitalized company destined for failure!
UCC Lien. A UCC filling on a business is a lien similar to a deed of trust on real estate. It will provide you with a recorded security interest in the assets you are selling. A buyer will not be able to get a bank loan on the business that will allow him to take his original down payment out of the company.
Additional Collateral. If you are providing ALL the financing for the business, you have the right to ask for a trust deed on the buyer’s house. (If the buyer is getting seller financing and a bank loan, the bank will take that collateral.)
Automatic Bank Payment. Your purchase contract should request that all loan payments to you be made by automatic bank debit. Buyer and seller should go to their bank on the day escrow closes and set up the transfer. Both parties must sing a ban contract authorizing the bank to take money out of the buyer’s account and put it into yours. Bank debits get paid BEFORE all other company checks, including payroll or rent. You will always get paid on the first day of the month before anyone else does. If there are insufficient funds on the first day, you will have first shot at the funds deposited during the next two days. This will eliminate those dreaded calls from the buyer asking for another ten days grace on his loan payment because his rent is due.
Financial Statement Review. If you make an investment, don’t you want to track its performance? In this case, you can request in the Asset Purchase Agreement that the buyer be required to provide you with financial statements on the business on a regular basis. As the seller, you will be in a good position to judge the performance of the business, and know if there is any reason for concern. You can also review the balance sheet to be sure your collateral is being maintained at a sufficient level.
Business theory will tell you that the greater the risk that an investor takes, the greater the reward he can expect. The rewards and investor can expect from seller financing will compensate him vey well for the risk that he is taking. A properly structured sales transaction can maximize the return that a seller can earn while minimizing his risk.
Higher Selling Price. Seller financing can have a significant impact on the potential selling price of a business. On the average, a seller can expect to obtain as much as 9% or more for his business if he finances 70% of the transaction. High seller financing yields a higher selling price than all cash transaction!
Tax Deferral. The Internal Revenue Service will allow portions of the taxes due from the sale of business property to be deferred into the future by the installment sale method. Non-recapture gains from the sale of capital assets can be deferred until the note holder (seller) receives principal payments in the future. This allows a seller to be taxed in future years when his tax bracket is probably going to be much lower. If a seller were to receive $500,000 in profits in the year he sold his business, he will find himself in the very highest income tax bracket – as high as 41% state and federal combined. If he received $50,000 per year over the next ten years, his combined rate would be 20% to 30%. The difference in tax brackets can mean a savings of up to $100,000 in taxes on a $500,000 gain!
Greater Interest Income. A seller note generally can bear interest at a higher rate than can be found on most other types of investments. Since a buyer can expect to pay as much as Prime plus 2% – 2.5% for an equivalent SBA loan, a seller note at Prime plus 1% or Prime plus 2 is a very attractive. At today’s prime a seller note can be priced at 8% to 9% interest. The seller is earning the 8% or 9% on his note BEFORE he pays the taxes from the sale of his business.
For example, if a seller received a $500,000 note with 9% interest, his interest payments alone would be $45,000 in the first year. However, if the seller received $500,000 cash when he sold his business he would end up with just $300,000 after taxes. He then would have to find an investment that would pay him 15% interest to earn the same $45,000.
A 9% higher selling price, a reduced tax bracket, and a high rate of interest paid on a before-tax promissory note, all translate into tens of thousands to hundreds of thousands of dollars in the seller’s pocket!
Keller Williams Business Brokerage
2005 Vista Parkway Ste 100 West Palm Beach, FL 33411
Cell- 561-352-3569 | Fax- 561-966-4008 | Email- email@example.com