Seller financing explained: when the owner helps you buy

Seller financing means the owner agrees to receive part of the price later instead of all of it at closing. You sign a promissory note, a written promise to pay that amount over time with interest, and the seller becomes one of your lenders.

It's a useful tool, and an easy one to misunderstand. With an SBA loan in the picture, a seller note doesn't always reduce the cash you need. Here's how it works.

Why an owner would agree

It can seem odd that someone selling their life's work would wait to be paid. But it often works in their favor too.

• More buyers can afford the company. A seller who insists on every dollar at closing narrows the field to buyers with more cash or a bigger loan.
• It can help with taxes. Under IRS rules for installment sales, a seller who is paid over time generally reports the gain as the payments arrive, rather than all in the year of the sale. Some parts of a sale, such as inventory and certain gains on equipment, don't get that treatment. The seller's accountant can say whether it helps.
• They earn interest. The seller earns interest on the note, which the IRS taxes as ordinary income. The note also has to charge at least a minimum rate the IRS publishes, or part of the payments can be treated as interest anyway.
• They believe in the business. An owner who's confident the company will keep earning is comfortable being paid from those earnings.

That last point matters to you. A seller who won't finance any of the price may simply need the cash, but when the company supposedly earns plenty, it's worth asking why.

The usual shape

A seller note is a negotiated agreement, so terms vary. The pieces you'll discuss:

• Amount, often a modest share of the price.
• Term, commonly a few years, shorter than the bank loan.
• Interest rate, agreed between you.
• Payments, typically monthly, starting at closing or after a delay.
• Security, often a lien on the business's assets (a legal claim on them if you don't pay) that ranks behind the bank's.
• What happens if you miss payments, spelled out in advance.

How SBA lenders treat it

When an SBA loan is part of the deal, the SBA's rules decide what the seller note does for you. There are two kinds.

A standby note. The seller agrees to receive no payments of principal or interest until the SBA loan is fully repaid, which on a purchase loan can be up to 10 years. A note like this can count toward your required 10% down payment, but only up to half of it. Interest can build up and be paid after the bank is repaid. This is the only kind of seller note that reduces the cash you bring.

A regular note. If the seller is paid along the way, the note doesn't count toward your 10%. It reduces how much you borrow from the bank instead. The lender counts its payments when it checks that the company can carry all its debt. If the note is interest-only, the lender tests it as if it were repaid over no more than 10 years. Together, the bank loan and a regular seller note can't add up to more than the business valuation the lender orders. Once a seller note has been in place and paid on time for 36 months, you can refinance it with an SBA loan, if the new loan meets the SBA's refinancing rules.

Expect the lender to set its own conditions too, like how the note ranks behind its loan and when payments may start.

An example with numbers

Say you're buying a company for $1 million that has owner earnings (profit plus what the owner pays themselves, before loan payments and taxes) of about $330,000, and you need a $100,000 salary. We'll use our usual assumptions: 10% down, about 4% in closing costs, and an SBA loan at about 10.25% over 10 years, where every dollar borrowed costs about 16 cents a year.

Without seller financing

• Your cash: $100,000 down plus $40,000 of costs, $140,000.
• SBA loan: $900,000, about $144,000 a year.
• After your salary, the company has $230,000 left, about 1.6 times the loan payment. SBA rules require at least 1.25 for a purchase like this.

With a $50,000 standby note

• Your cash: $50,000 down plus $40,000 of costs, $90,000.
• SBA loan: still $900,000, still about $144,000 a year.
• The seller gets their $50,000, plus the interest that has built up, after the bank is repaid.

You keep $50,000 more in the bank, and the seller waits a long time.

With a $150,000 regular note over five years at 7%

• Your cash: still $140,000.
• SBA loan: $750,000, about $120,000 a year.
• Seller note: about $35,600 a year.
• After your salary, the company has $230,000 for about $155,800 of payments: about 1.5 times. In five years the seller note is paid off and only the bank loan remains.

Your cash doesn't change, but you owe the bank $150,000 less, and the seller has a reason to want the company to do well while they're being paid.

Without an SBA loan, there's no fixed rule. A buyer and seller can agree to any split, and some smaller purchases are financed largely by the seller. That can mean a smaller down payment, but the protections and terms are entirely what you negotiate, so an attorney matters even more.

A Florida detail

Florida charges a documentary stamp tax on promissory notes signed or delivered in the state, at 35 cents per $100 of the note. According to the Florida Department of Revenue, the tax on a note is capped at $2,450. A mortgage on Florida real estate is taxed differently, without that cap. On a $150,000 seller note, the tax is $525. It applies to the bank's note too, so include it in your closing costs and let your attorney handle it.

Protecting both sides

Put the whole arrangement in writing with an attorney: the note, a security agreement giving the seller a lien on business assets, and the agreement with the bank about who gets paid first. Talk about what happens in a bad year before you sign, not after. If the seller is also helping with the transition, keep that agreement separate and clear, so a disagreement about one doesn't spill into the other.

How to raise it

Bring up seller financing once there's trust, not in a first letter. Frame it as shared confidence: you'd like them to stay invested in the company's success while it passes to you. Put the proposed amount, term and rate in your letter of intent, the short document that sets out the main terms of an offer. Our post on what goes in a letter of intent covers the rest of that document, and your deal team explains when to bring in your lender and attorney.

What to do this week

• Rerun your numbers three ways: no seller note, a standby note and a regular note.
• Ask a lender how they'd treat a seller note on a deal your size.
• Read where the down payment comes from for how a standby note fits with your other sources.