What is seller financing and when does it make sense?

Short answer: Seller financing means you lend part of the purchase price to the buyer through a promissory note, receiving those payments over 3 to 7 years with interest. It enables deals that would not otherwise close, often at a higher total price. The trade-off is deferred cash and default risk. Whether it is worth it depends on the buyer's quality and your personal liquidity needs.

How seller financing works in a deal

At closing, instead of receiving 100 percent of the purchase price in cash, the seller receives a percentage in cash (often 70 to 90 percent) and the remainder as a structured loan from the buyer. This loan is documented as a promissory note, typically secured by the business assets, and subordinated to any senior bank debt the buyer is using.

When seller financing helps the deal

Seller financing is most commonly required when the buyer's financing does not cover the full purchase price. This happens in three situations:

• SBA-financed deals: SBA 7(a) loans, which are common for deals under $5M, require a seller note of 5 to 10 percent as part of the loan structure. The SBA mandates this to ensure the seller retains some stake in the buyer's success.
• Management buyouts: As covered in the MBO article, management teams typically cannot raise enough external capital to fund the full price. A seller note of 20 to 40 percent bridges the gap.
• Higher-price deals with leverage constraints: In any leveraged acquisition, the maximum debt the business can support (based on cash flow coverage ratios, typically 2 to 4x EBITDA) sometimes falls short of the agreed price. A seller note fills that gap without requiring the buyer to bring additional equity, which would reduce their return.

The price benefit

Sellers who offer financing often command a higher purchase price than sellers who insist on all-cash. Buyers can justify paying more when a portion of the price is deferred and linked to the business's ongoing performance (in their view, the seller is expressing confidence in the business by carrying the note). A business that sells for $18M all-cash might sell for $20M or $21M with a $4M seller note. Whether the premium compensates for the deferred receipt and default risk is a calculation specific to each deal and each seller's circumstances.

The risks the seller carries

The seller note creates real, unsecured credit exposure. If the buyer fails to operate the business successfully after closing, the seller faces:

• Deferred or missed interest payments
• Default on the note principal
• The unpleasant choice of taking the business back (if there is a security interest), pursuing legal remedies, or negotiating a haircut on the balance owed

Mitigations include personal guarantees from the buyer (if buying as an entity), subordination agreements that define precisely what triggers a default, financial covenant requirements with quarterly reporting, and life insurance on the buyer's life with the seller as beneficiary. These protections should be negotiated explicitly in the purchase agreement and promissory note, not added as afterthoughts.

Tax treatment of seller financing

Seller notes can structure gain recognition over the life of the note using installment sale reporting (IRS Form 6252). Rather than paying capital gains tax on the full purchase price in the year of sale, the seller recognizes gain as each payment is received. This can reduce the effective tax rate if the seller expects to be in a lower tax bracket in future years. However, there are limits: installment sale treatment is not available for publicly traded property or for situations where the total sale price exceeds certain thresholds. Consult a tax advisor before assuming installment sale treatment applies.