Colorado Seller Financing: Seller Carry Done Right
A “seller carry,” or seller financing, is a loan provided by the seller of a business to the purchaser. When it comes time to sell a business, many sellers find it necessary or advantageous to carry all or a part of the purchase price. By carrying a part of the purchase price, a seller will find a larger buyer pool, command up to 15 percent more in the purchase price, and increase the total sales price by requiring interest (as much as 8 to 10 percent over a 5-10 year period).
Advantages of the seller carry
A seller carry can give the business owner a greater pool of potential buyers. For example, key employees, family members, or other individuals that are qualified to run the business but lack assets or the ability to obtain a loan from a third-party financial institution, can become viable prospects.
If a business is distressed and losing money, a seller carry may be the only alternative to bankruptcy or involuntary liquidation. Most financial institutions require three years of strong financial performance of the acquisition target before it will lend to potential buyers.
Finally, an owner willing to carry part of the purchase price will typically command a higher purchase price to account for the greater risk involved to the seller. Further, sellers can rightfully demand a reasonable interest rate far above current interest rates during the term of the carry.
The power of interest
Typical interest rates for a seller carry can be 8 to10 percent over a five to ten year period. That means, for example, a $500,000 loan from a seller at 8 percent interest paid off in five years will generate over $100,000 in additional interest income during that period.
At a minimum, seller financing will help the seller avoid having to reduce the purchase price of the business during tight financial markets. Done correctly, seller financing can be a profitable venture for the seller of a business.
Disadvantages of the seller carry
A seller carry is not without risks, and a default by the buyer on the note can be disastrous to the seller. In many cases, the sale of the business represents the seller’s retirement, and the seller may not be able to recover if the buyer does not meet their obligations.
The seller is relying on the buyer to profitably operate the business, keeping the seller tied to the business owner long after the sale. If the buyer fails, the seller may be stuck with an uncollectible note and a former business that is losing money and lost its reputation. The seller may not have time or the energy to fix it.
Protect Yourself in Three Steps
Sellers must remember that they only have one time to sell the business correctly. Legal help is absolutely mandatory to ensure that the note is properly secured and the security interests are perfected as to other creditors.
Far too often litigation attorneys are attempting to collect on unsecured and improperly drafted notes. Sellers must consider themselves the bank and act accordingly – security, security, security!
Step One: Know the buyer
The seller must know the buyer in a seller carry. The seller should interview the buyer and learn about his or her experience in the industry, past employment, specific trade experience and general managerial experience. As most sellers will attest, thinking you can run a company is a far cry from actually running a company.
The seller must also conduct due diligence, and search public records to figure out all of the buyer’s assets and liabilities. This includes judgments, lawsuits, tax liens, real estate, personal property and criminal records.
The seller needs to see the buyer’s tax returns (at least three years), bank account balances, and other assets statements such as 401(k), IRAs and stock accounts.
Step Two: Buyer’s personal liability
Sellers must require a down payment sufficient from the buyer to ensure that they are committed to making the purchased business a success. The amount that the seller pays can vary widely.
The buyer must personally guarantee the payment of the note. If the buyer lacks assets, or those assets are protected (for example, 401(k) assets) then the seller should also insist on other guarantors. Spouses and family members are often used as additional guarantors of the note.
Step Three: Security
In addition to the personal buyer guarantees, the seller must get adequate security. Security includes encumbering homes, the assets of the business being sold, cars and other property.
It is imperative that the security interest is also perfected properly. When a security interest is perfected property, it give the seller priority over later creditors if the buyer files for bankruptcy or fails to pay the seller or any other debt.
If you have questions on selling a business using seller financing, contact our business attorneys at 303-688-0944.