Seller Financing: The Best Way to Buy a Business
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The greatest return on capital is found in the most boring place: investing in your own business. People want to tell stories about making millions through crypto, stocks, real estate, & other ventures. In the real world placing a bet on yourself by expanding your business is best investment you can make.
When most people think of buying a business they assume they only have 2 options: pay in cash or go to the bank for a loan. It could take years to build up sufficient cash and getting a bank approval could be challenging and time consuming based on the bank's requirements.
There is a third option that has a tremendous amount of power: Seller Financing.
Seller financing is the process in which the seller of the business becomes the bank. They "carry the note" allowing you to make monthly principal & interest payments directly to them instead of paying the bank.
2 Key Metrics: Cash Flow & Cash-On-Cash Returns
When it comes to buying a business we look at two key metrics: projected cash flow & cash-on-cash return.
Projected Cash Flow - how much cash we believe the business can generate, after subtracting our debt payments, over next 12 months once we implement our pricing, process, marketing, & training.
Cash on Cash Return - our year 1 cash flow divided by our initial cash into the deal.
Buy a business for $300,000 that currently cash flows $100,000 per year. Put 20% down ($60,000) and seller finances the remaining $240,000 at 4.5% interest for 7 years with an annual debt payment of $50,000.
At minimum we expect to maintain the $100,000 in cash flow minus our $50,000 debt leaving us with $50,000 in cash flow, giving us a 83% cash-on-cash return ($50,000 CF / $60,000 down)
Knowing we are good operators, we expect to increase the cash flow to $150,000, minus our $50,000 debt, generating $100,000 of cash flow and giving us 160% cash-on-cash return ($100,000 CF / $60,000 down
Our best deal generated almost 800% cash-on-cash return. You can’t those returns anywhere except maybe Doge Coin
Why would a seller do that?
A seller is willing to finance a business sale for a number of reasons:
We've worked with a number of sellers who didn't know they could finance the sale. Usually once we ask a few questions and walk them through the benefits they are intrigued and want to learn more.
Tax Benefits for Seller
Disclaimer: I'm not a tax expert so consult with your CPA. When selling a business using an installment sale (seller financing), you pay federal taxes that year in correlation to the percentage of principal you received that year. The best part for the seller is the additional interest income they receive from the buyer pays their tax bill plus some!
Seller carries a note for $300,000 for 10 years
Incurs capital gains tax of $50,000
In Year 1 Seller receives 7.9% of the total principal so they would owe 7.9% of the total capital gains, $3,950 of the $50,000
In Year 2 Seller receives 8.3% of the total principal and owe 8.3% of the capital gains.
In this example the Seller is receiving an additional $14,461 in interest in Year 1. Over the term of the loan the additional interest the seller receives ($82,000) covers all the capital gains they owed from the original sale ($50,000) even after paying the incremental taxes on the interest payments ($27,000)
As a buyer there are number of benefits to utilizing seller financing
Again, consult a CPA here: There are some extremely good tax benefits to the buyer of a business as of 2021. When you buy a business the sale price is broken down into 3 components: (1) FF&E (furniture, fixtures &equipment), (2) inventory, (3) goodwill.
Inventory doesn’t depreciate and goodwill is deducted equally over 10-15 years. The magic happens with the FF&E. You are able to depreciate approximately 80% of the FF&E portion of the purchase price in the year you buy the business.
Purchase Price: $100,000 with $20,000 down
Purchase Price Breakdown:
Year 1 Tax Deduction: 80% x $80,000 FF&E = $64,000
Taxes Saved: $64,000 x 32% = $20,000
In this example we put $20,000 down and saved $20,000 in taxes thanks to bonus depreciation. Net cash into the deal = $0.
Seller financing has the flexibility to creates a win win for both sides. The seller note has every component a traditional bank note does:
Sale Price - the sale price of the business. Determine business valuation is a huge topic within itself with lots of variables. A rule of thumb is many small businesses trade at 2-3X annual operating profit. A business that makes $100,000 per year is worth $200,000 to $300,000.
Down Payment - the portion of the sale price you pay at closing. Most banks want 20%. You and the seller could agree on anything from 0% down to 50% or more.
Interest Rate - the cost of the loan depending on the risk. We've had success in getting market rates of 4-6%. All depends on your relationship with the seller. The higher the perceived risk by the seller the higher interest rate they will want.
Amortization - how long you are going to spread out the payments. Bank loans are usually 10 year amortizations. The amortization has a huge effect on your monthly cash flow. As a buyer you'll want a longer amortization to spread out your payments and increase your cash flow. The seller will want sooner. The amortization will depend on the size of the loan. We've down a short as 4 years and as long as 10 years.
Term - when the final payment is due. The term could match the amortization period or the term could be shorter which means you would have a balloon payment. For example you could have a 10-year amortization which lowers your monthly payment with a 5-year term. At the end of 5 years you owe the balance of the loan. You will have to plan ahead to have the cash for the big payment, go to a bank for a traditional loan, or attempt to get the seller to do another 5 year term to complete the 10 years.
Interest-Only Period - you could negotiate a period of interest-only payments. We've proposed this structure when renovations were required in order for the location to meet our standards. The interest-only period helps your cash flow while the business is getting started. You won't have much success getting an interest-only period with a turn-key operation.
Prepayment Penalty - a penalty the borrower would pay the seller if they want to pay off the loan sooner than the initial term. A seller may want this to guarantee a certain amount of interest payments. A borrower may not want a prepayment penalty if they plan on refinancing.
Points - also known as a loan origination fee. While it’s normal for banks to charge a fee of 0.5% to 2.0% of the loan amount, it’s extremely uncommon for the seller to charge points. Stand your ground if they ask!
Collateral/Security - the assets you are putting up to secure the note. If you default on the loan, the seller has the ability to take possession of these assets in order to be made whole. The amount and type of collateral will depend on (1) the size of the loan, (2) your relationship with the seller and (3) the risk perceived by the seller. At minimum the assets of the business being sold will be collateral. From there it's up to you and the seller. The seller may ask for a corporate guarantee, a personal guarantee or even a lien on real estate. As the buyer you want to put up the least amount of collateral necessary to get the deal done while the seller wants the maximum.
Establishing a relationship & trust with the seller is the most critical step in getting a seller-financed deal. A seller has to believe that you are going to succeed in operating the business you are buying. While the seller is going to have security on the note, the last thing they want to deal with is suing you to collect payment or assets after you default.
Put together a case study to show how you took the business from $A to $B by implementing new processes, training the right people, improved the marketing, etc. Write a professional business plan if you really want to impress the seller.
“Proximity is Power” - Tony Robbins
Having proximity to the seller is the best way to establish a relationship and create trust. If possible start the relationship with the potential seller prior to the subject of selling the business comes up. Get lunch on a regular basis to discuss you individual businesses, best practices & challenges. You have an open line of communication to call each other with operational questions.
Be Patient & Follow Up
It usually takes a lot longer to get a deal done than you expect it to so be patient. A seller who's owned the business for 20+ years likes the idea of retiring but they don't know what they want to do next. The conversations/negotiations may go on for months until the seller gains clarity on their future.
While you want to be patient you also need to stay in communication. Try to nail down next-steps with specific dates if possible. Follow up on a regular basis without being annoying.
Now Go Get It
As a business owner you have the opportunity to create any future that you can imagine. The first step is to create a strong vision of the life you want to live. A vision so strong that it motivates you every day to take action. Investing in yourself and in your business provides the greatest return on capital. Compounding those returns is how you build wealth.
You could go at it alone or you can turn decades into days by working with a business coach. As a coach I work 1-1 with individuals helping them co-create an exciting future. If you are interested in learning more about coaching email me at firstname.lastname@example.org or book a discovery call
If you have any questions related to buying a business with seller financing comment below: