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If you are selling a small business, the buyer might ask you to take a promissory note from it for part of the purchase price. This is called "seller financing." Buyers ask for seller financing because they might not have enough cash for closing, they might not be able to get a commercial loan, or they might not be able to get enough money from a commercial loan.
Seller financing is common in many small business sales, and many small business sales might not happen without it, but a seller should be diligent in its consideration of whether to agree to it. Here are some questions sellers can ask when making that decision:
Why is the buyer asking for seller financing? Is it unable to get a commercial loan? Or, is it getting a commercial loan for a portion of the purchase price, but doesn't have enough cash to pay the difference between the purchase price and the loan proceeds?
Do you want to be a lender? You will be making a loan and becoming a lender, so you should act like a commercial lender. This means you should do a credit check on the buyer to analyze the potential credit risk before deciding to agree to seller financing. The loan should be documented in the appropriate legal documents similar to those a commercial lender would use. You should charge interest. You should also obtain a personal guaranty from all the owners of the buyer and a lien in the buyer's assets as collateral to secure the loan. You should perfect your lien by recording a UCC financing statement against the buyer.
Will you be second in line behind a commercial lender? If the buyer has a commercial lender, the commercial lender will require that you subordinate your loan, meaning that the commercial lender will always be in a first position. The commercial lender will have superior rights to get its debt paid before you get your debt paid. This could be a big issue if the buyer defaults because the commercial lender will control all collection efforts (even controlling what you can and cannot do to collect) and may exhaust all the buyer's financial resources for repayment, meaning there might not be any money left to pay your debt.
Will you have to defer receiving payments on your loan? Lenders for certain types of commercial loans might require you to defer payments under your loan until their loan is paid off. For example, if the buyer is getting an SBA loan for a portion of the purchase price, you will probably be asked to sign an SBA Standby Creditor's Agreement in which you promise that you will not take any payments on your debt until after the SBA loan has been paid off. This can be a surprise for some sellers because they expected to be receiving payments under the promissory note immediately after closing.
Are you willing to enforce your collection rights if the buyer defaults on its promissory note to you? One of your remedies when enforcing your loan is to take over ownership of the assets or business. If the buyer has defaulted on its loan, the business probably is not in very good financial shape. Are you prepared to take on the responsibility of operating, and perhaps rebuilding, the business, if the buyer defaults on your loan? Or are you ready to take control of the business and sell it again to try to recover your loss?
If you have any questions or concerns about seller financing or need help buying or selling a small business, you should contact me at joel@jalawoffice.com.