Sep 10, 2022

Securing a Seller Note in a Small Business Sale

Will Simmons
Will Simmons
Transaction Advisor

Will is responsible for helping sellers market their businesses to prospective buyers and providing hands-on support from offer to close. Using his background in mergers and acquisitions at Wells Fargo, he drives value and provides clients with the necessary resources, best practices and advice for a successful sale of their business.

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Over 90% of the transactions through Beacon include seller financing. We have a number of posts that dig into topics surrounding seller financing, from our general overview to our post about how using an SBA loan to buy a business can impact seller financing.

During negotiations around a business sale, business owners are often concerned about their recourse if the transition falls through. "How can I make sure I get paid?" After all, they’ve typically financed at least 10% of the purchase price of the business and want to ensure that they get compensated.

In this post, we dig into the three common ways that a seller note in a small business sale can be secured.

No Security

The first option for securing a seller note is to simply not secure it. In this case, if the note is not paid, the lender (e.g., the former business owner) will need to take the borrower (e.g., the new business owner) to court. The first step will be that the lender will need the court to make a judgment on the amount owed. The second step will be that the lender will need to enforce the judgment against the borrower’s assets.

Obviously, most buyers would prefer an unsecured seller note. Their logic may be that the note should only get paid in full if the transition is smooth, as the note helps to share the burden of transitioning the business from one owner to another.

On the other hand, most sellers will disagree unless the purchase price and amount being seller financed have been discussed at the outset. Most sellers will argue that the borrower is paying a price for their businesses and need to make good on paying that price in full. The seller is acting as a bank and deserves to have the protections of a bank.

Lien on the Business: Secured by the Business

The second option for securing a seller note is to use the business as collateral. In the event that a borrower fails to make good on a seller note, the lender (i.e., the former business owner) can lay claim to the assets of the business. This can range from selling off the fixed assets to cure a default on the seller note to the previous owner taking back over the business altogether.

The pro of this approach is that it more clearly ties success and failure of the transition to the business. It allows the buyer to avoid making a personal guarantee. It forces the owner to be incentivized to transition the reins successfully.

The con of this approach is that many owners sell their businesses to retire. They may not want to go through the hassle of taking the business back over. Additionally, there can be complications if a bank loan is involved. When an SBA loan has been used to purchase the business, there are often restrictions (or, “loan covenants”) to abide by. The SBA loan is also typically “senior” to the seller financing. In other words, the SBA lender gets “first dibs” before the owner can take the business back over.

Personal Guarantee: Personally secured by the Buyer

The third option for securing a seller note is to have a personal guarantee by the buyer. In this case, the buyer’s personal assets are on the line in the case of a default. If he or she runs the business into the ground, the selling business owner will have a clear path to lay claim to their personal assets.

Although most buyers do not like this option, as they believe a seller note should align incentives for the selling owner to help them be successful, it is still quite common on “main street.”

The pros for this approach are that it clearly forces the buyer to remain accountable for the transition and ensures that an owner can pursue full payment without having to take the business back over.

The con for this approach is that it does not help incentivize the selling business owner to aid the new buyer in getting off to the races. Instead, it puts the ball squarely in the new entrepreneur’s court.

Our Recommendation

At the end of the day, whether or not to secure a seller note (and how to secure it) is a deal-by-deal decision. It depends on how confident the selling owner is in the buyer and his or her business. It depends on how seller financing was structured in the transaction and what expectations were set upfront. 

When possible, we love to see when seller financing comes without security or with security via the business as this aligns incentives best. However, there are often cases where it makes sense to secure the seller note by the buyer, especially if the seller note makes up a majority of the “funds” used to purchase the business.

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