Understanding Seller Financing
In this arrangement, a business seller offers financing for the acquisition of the company to the buyer. Rather than the buyer borrowing the full amount of the purchase price from a bank, the seller agrees to accept a promissory note for part of the purchase price with a specified interest rate and a specified repayment period. The balance will be financed through bank financing obtained by the buyer or from the buyer’s cash resources.
Seller financing is almost always present when a small business is being sold; the seller will offer financing that is either explicit (i.e., through a promissory note) or implicit (i.e. , through an adjustment to the purchase price). It is not uncommon for sellers to insist on holding back 20-30% of the purchase price in the form of a promissory note. While the buyer is usually eager to show that the deal is happening without requiring seller financing, the effect of the negotiation of the price offset by a seller note essentially results in seller financing.
For the buyer, the advantages of seller financing include:
The seller also has advantages, including:
The disadvantages for the buyer are:
The disadvantages for the seller are:
Seller financing can be a huge incentive to buyers when they are purchasing a business. However, the seller should carefully evaluate both the advantages and disadvantages before proceeding.
Key Components of a Seller Financing Agreement
A seller financing contract contains the same basic components as any other real estate contract, such as the purchase price and closing date. However, it must also contain several key elements to be valid, and most importantly, to ensure that your interests are protected.
First is the down payment. Often, a real estate agent will require that a minimum, such as 10 percent or 20 percent, be put down, but as a seller, you can choose a lower number. If a potential buyer offers you 8 percent as a down payment, you can accept it. On the other hand, if you’re set on getting 20 percent and don’t need to sell the property quickly, then you can just reject the offer.
Next is the interest rate. One advantage to seller financing is that you can set the interest rate. This can be an attractive selling point in a volatile real estate market. You can promise a favorable interest rate, say the current prime rate, to attract more buyers into your market. Or you can promise a lower rate to attract those who can’t secure a mortgage.
Seller financing has an advantage over conventional financing in that there is a lot of flexibility with most of its elements. It also comes with some risks that we’ll explore next.
Creating a Reliable Contract Template
Once you have a basic understanding of the components of a seller financing contract, you will want to create a template version for your business. There are many options for how you adapt your template to fit your needs. For instance, the template you create for selling your personal services will be different from the ones created for selling a large company or property. If your transactions vary significantly from one to the next, you might choose to leave a lot of blank spaces in your template and fill them in as needed for each transaction. If you are using seller financing contracts for your services, or you are making smaller scale sales, a better strategy might be to create "fill-in-the-blank" templates ahead of time so that when you come across a buyer, you can fill in the name, price, payment plan or interest and print it out to use immediately. A simple seller financing contract template will usually include basic elements like the names of the parties, the date that the contract was drawn up, details about the amount being financed, any interest amounts or percentages, terms for late payment, how payments are to be made, default terms and any additional agreements. If money is to be held in escrow between the parties, or if any outside parties are involved in the contract, you would add those components as well. Regardless of the business type you are working in or the size of the transaction, you will want to make sure that your contract template covers the seller financing components that pertain to your situation. Generally, you will want to make sure that your contract template includes all of the necessary terms of the contract so that when you fill in the blanks later, you won’t forget to include some aspect of the deal. Your agreement will also be more binding if you have set as many of the terms as possible in advance of closing the sale.
Legal Aspects and Considerations
When entering into a seller financing agreement, the parties must be aware of various legal requirements and disclosures that are necessary to ensure compliance and protect their interests. State and federal laws have specific provisions regarding disclosures and procedural requirements for seller financing agreements, which vary from state to state, and these laws must be adhered to in both the preparation and completion of the sale. For instance, the federal Truth in Lending Act requires certain written disclosures in connection with a residential mortgage transaction. The Consumer Financial Protection Bureau (CFPB) also has specific regulations applicable to residential mortgage loans, including those that require lenders to provide disclosures to borrowers if a loan contains features such as a balloon payment or prepayment penalty, as well as a good faith estimate of the total monthly payments expected. Certain financial disclosures are also required in many states, which are generally intended to show the borrower’s ability to afford making the payments for the property, including principal, interest, taxes and insurance .
Both the buyer and seller should seek assistance from legal counsel in drafting a seller financing agreement and then adhering to all necessary legal requirements in the transaction. Proper drafting and compliance with applicable laws can not only avoid potential liability and or issues (legal and/or otherwise) in the future, but also ensure the enforceability of the transaction. Typically, in most situations where the buyer defaults on the seller financing agreement, the seller will need to pursue an unlawful detainer action to remove the buyer from the property and recover possession, and the buyer is only entitled to damages in certain, limited circumstances, such as where the seller engaged in fraud or misrepresentation. The only way for the seller to receive clear title to the property if the buyer defaults, however, is by reconveying the property back to the seller after a foreclosure proceeding. In most cases for a seller financing agreement, the parties are typically looking at judicial foreclosure rather than non-judicial foreclosure, and while it may take longer, the seller usually ends up with greater protections and benefits that way.
Common Pitfalls to Avoid
Be cautious about leaving blank spaces in the contract for Seller Financing. For instance, if you leave spaces for the down payment without filling them in, sellers may think that the buyer can borrow the down payment from another source, and that will be acceptable to them. Not so! The seller will look to the contract in force at the time for payment of the down payment. If there is a zero figure in the contract, that is exactly what it means. Buyers will also mistakenly fail to seek a receipt from the seller for the down payment. There are usually several cash payments made by the buyer to the seller before closing, and all of those bring the buyer closer to the down payment amount called for in the contract. All payments by the buyer, no matter how small or how often made, should have a receipt issued. Immaterial amounts should be treated in the same way as large amounts, to avoid dispute later.
It is important to ensure that everyone involved has a good understanding of the concepts present in a Seller Financing contract. For instance, the buyer should know about the cost of closing for the transaction, and how the seller financing and contended offsets will play into their contribution to that cost. The seller must be informed accurately and completely, so that they have a full appreciation for what that cost will be, so that they are not surprised by receiving less than they expected.
Seller Financing is an excellent opportunity to buy a business with limited cash, but it is essential to complete the transaction correctly.
Resources and Support
While the provided contract templates will be suitable for many sellers and buyers, it’s important to know that there are resources available should you require more specific guidance. One option is to enlist the help of an attorney who specializes in real estate transactions. They can help you draft a tailored seller financing contract that suits your agreement precisely, covering any unique aspects or contingencies that may arise in the negotiation process . For those who prefer to do their due diligence independently, consider the wealth of information available online. Websites dedicated to real estate and law often contain articles and FAQs on seller financing. Online forums can also be a treasure trove of insights, with experienced individuals sharing their firsthand experiences and advice. Local real estate groups and clubs are another potential resource. Networking with other professionals in the field can not only lead you to other experts, but can present opportunities to share resources amongst peers.