Owner financing might sound complex, but it’s essentially a way for business owners to sell their business while playing the role of the bank.
In this guide, we’ll walk you through 10 different ways you can provide owner financing.
Let’s start here.
What is owner financing?
Think of it as a DIY approach to funding a business sale.
This method can be a win-win: sellers often get a better price for their business, enjoy some tax perks, and avoid the hassle of traditional bank loans.
But there are also some risks involved.
Some potential benefits of providing owner financing:
- The seller can get a higher sale price.
- There could be some nice tax advantages.
- It can be faster and easier to close the deal.
- It can provide a recurring stream of income.
There are also some risks. These include:
- The business may not perform as well as expected after the sale.
- The buyer might struggle to make payments and put the seller’s income at risk.
- Interest rates may rise significantly during the financing period.
And of course, when the seller provides financing, they will have less liquidity than if they had received a lump sum payment, which may limit their ability to make other investments.
Keeping that in mind, here is a very simplified overview of 10 different mechanisms available for an owner of a business to provide some financing to a prospective buyer.
1. Earn-Out Agreement
An earn-out agreement ties the purchase price of the business to its future performance.
The buyer pays an initial amount upfront and agrees to make additional payments based on the business’s financial performance over a specified period.
This type of financing is common when the business’s future earnings are uncertain.
2. Equity Ownership
In this option, the seller retains an equity stake in the business and acts as a silent partner or shareholder.
The buyer operates the business and makes payments to the seller based on the agreed-upon percentage of ownership.
3. Earn-In Equity Agreement
This is an option for situations where the buyer is a key employee that is instrumental in the success of the business.
The buyer is motivated to purchase the business but does not have the ability to make an outright purchase with cash and or debt.
The buyer would have a Profit Interest Agreement that would provide the buyer with the means to purchase equity from the Seller over time with the proceeds from the profit interests.
The terms of the equity purchase are provided in an Equity Purchase Agreement.
The buyer pays an upfront amount for an initial purchase of equity and pays an option fee to the seller, to buy future equity.
The seller and buyer agree on a purchase price that represents the future potential of the business and the seller receives a preferred payment (think of it as interest) for financing the deal.
The Seller remains in control until such time the buyer has purchased the majority of the shares (51%), then the control goes to the buyer.
4. Promissory Note
This is one of the most straightforward forms of owner financing.
The seller extends a loan to the buyer, who signs a promissory note outlining the terms of the loan, including the interest rate, repayment schedule, and consequences of default.
The buyer typically makes regular installment payments to the seller until the loan is paid in full.
5. Installment Sale
In an installment sale, the buyer agrees and has the means to purchase the business over time by making a series of installment payments.
These payments can be monthly, quarterly, or annually.
The seller retains ownership of the business until the buyer completes all payments.
6. Lease Option
The seller leases the business to the buyer with an option to purchase it at a specified price later.
A portion of the lease payments may be credited toward the purchase price if the buyer chooses to exercise the option.
7. Seller Note Collateralized by Assets
In this option, the seller secures the financing with assets or collateral from the business.
If the buyer defaults on payments, the seller has the right to repossess or take ownership of these assets.
8. Seller-Financed Mortgage
This is commonly used in real estate transactions but can apply to the sale of a business with real estate.
The seller provides financing in the form of a mortgage, and the buyer makes regular mortgage payments to the seller until the loan is paid off.
9. Convertible Debt
In some cases, the seller may provide financing in the form of convertible debt, which can later be converted into equity ownership in the business if certain conditions are met.
Converting debt to equity is a complex financial transaction that requires the involvement of legal and financial professionals who can ensure compliance with all applicable requirements and protect the interests of both the debtor and creditor.
10. Subordinated Debt
In subordinated debt financing, the seller’s loan is secondary to other debt obligations, such as bank loans.
This means that the seller will only receive repayment after secured debts (banks debt) are satisfied, which may be riskier but can make the business more attractive to buyers.
Get expert advice
As you can imagine, each of these owner financing types comes with its own advantages and risks, and the specific terms can vary widely.
Having a good legal advisor, along with a great business advisor on your team will be important.
If you’d like some expert guidance, book a call with one of our family business advisors: book a call