Considerations for Seller Financing in an Ever-Changing Market

By: Clayton Lee Lovett

Recent market trends have led to an increasing number of transactions involving seller financing in some aspect of the overall deal structure. Understandably, most sellers prefer not to provide financing as a condition for closing a transaction, favoring cash or traditional financing instead. However, seller financing is becoming more common—and sometimes necessary—for risk-tolerant sellers who want to make their terms more attractive to a broader range of buyers, with the added benefit of increasing the chances of a quicker closing timeline.

From a buyer’s perspective, Seller financing is attractive because it provides greater access to credit. Traditional lenders often require lower loan-to-value ratios than those typically seen in seller financing. This benefit extends beyond the closing date, as buyers can use their cash for business operations rather than tying it up in the purchase. Additionally, seller financing rarely imposes post-closing restrictive financial covenants on buyers, such as debt-to-equity ratios or fixed-cost coverage ratios. An added advantage for both buyers and sellers is the reduced bureaucratic red tape, most often encountered in Small Business Administration financing, which can result in a faster closing process.

Despite these benefits, sellers should not commit to seller financing without a thorough understanding of the associated risks and tradeoffs. Below are considerations sellers should discuss with their advisors before committing to seller financing:

1. What is my collateral?

• Instead of being the sole source of financing for a buyer, such as through a real estate loan, capital loan, or floorplan line of credit, sellers often offer financing to supplement traditional credit sources.
• One crucial question for a seller is: “In the event of default, what is my collateral?” A first-position mortgage on the real estate associated with the business is one of the most secure forms of collateral. However, buyers can often secure better terms through traditional financing on real estate, leaving sellers to provide financing based on the goodwill and assets of the business without holding a mortgage on the real estate. This situation can be complicated if the buyer’s traditional lenders require seller financing to be subordinated, necessitating intercreditor agreements between the lenders and the seller.
• Early discussions with the buyer should clarify what additional financing they will obtain and what collateral commitments they have made with those lenders. If the seller cannot hold a mortgage on the property or if their commitment exceeds the property’s value, they should consider other forms of security, such as corporate and personal guarantees, or liens on unrelated properties.
• Another way in which sellers may address risk is with an interest rate of 50-100 basis points over “market” interest rates.  

2. Interest Rate Risk

• Most seller financing is under fixed-rate amortization terms rather than variable rates that track market changes. This arrangement reduces the administrative burden of managing the debt day-to-day but exposes the seller to the risk of debt devaluation due to interest rate fluctuations. Sellers can mitigate this risk by structuring the debt with shorter-term balloon payments, and buyers often seek the ability to prepay the debt without penalty to refinance in a more favorable market.

3. Additional Costs

• Sellers may overlook the additional costs associated with drafting and negotiating loan and security agreements. In traditional financing, the lender’s legal costs are passed to the borrower. However, in seller financing, unless a cost recoupment agreement is negotiated upfront, each party typically bears its own legal fees. Additionally, parties should consider extra costs and fees related to recording security agreements and, as may be applicable in some states, documentary stamps.

4. Consult Your CPA and Tax Advisors

• Depending on the specific facts and circumstances of a transaction, seller financing can allow a seller to defer recognition of gain on the sold assets. Sellers should consult with their CPA and tax advisors to fully understand how seller financing will impact their finances.

Seller financing may at times be a key bridging item that brings a negotiation to contract.  Before committing, Sellers should carefully weigh the advantages and disadvantages of acting as a bank, and seek the assistance of experienced legal and accounting transaction professionals.