What Is Seller Financing?

PE firms often leverage target companies to increase the probability of reaching target returns. Leverage is a useful tool because it helps generate the necessary capital to drive profitable improvements all while keeping the initial price at a reasonable level.

Firms can use senior bank credit or a mezzanine debt strategy to achieve leverage, but there are times when bank financing doesn’t fit or dries up (a major problem in 2008 and early 2009, for example). A third, less heralded form of financing is known as “seller financing” or “owner financing,” whereby the seller agrees to help finance the transaction.

How Seller Financing Works in a Business Purchase

Credit markets aren’t always priced to everyone’s liking, so the parties to a deal sometimes need to get creative to find a solution. The quintessential seller financing scenario involves a small deal with a privately-owned target company and an acquirer with limited capital. If both sides are committed to making it work, the seller might agree to finance a portion of the deal over a specified term — usually three to seven years — with the buyer acting as the debtor.

Notes are often non-guaranteed, but sellers can push to receive a corporate guarantee or principal guarantee. Normally, the acquiring party makes a down payment and the seller carries a promissory note (“seller paper”) for the rest of the purchase price. Conceptually, a seller-financed acquisition isn’t much different than going shopping on a store credit card.

Payment terms on seller financing agreements are extremely flexible. Interest can be deferred or payments might be interest-only for the first six-12 months. Many end with balloon payments. Increasingly, deals involve other provisions based on the performance of the acquired business.

“There is a spectrum of seller financing mechanisms,” according to Leonard Washko, Senior Analyst at Sunbelt Business Advisors, an Axial member. These include “pure debt, notes contingent on performance, even equity participation.” Some involve changing the risk structure through earn-outs – a form of incentive to keep key players on board after the transition period or to protect the firm from overpaying.

“In every deal, both sides must reach an acceptable level of risk to reach a closing,” says Washko. “We have found it is smart for both seller and acquirer in the middle market to consider how seller financing can be employed to change the risk structure.”

Pros and Cons of Seller Financing

On the surface, seller financing immediately disadvantages the seller, who must wait to receive full payment after control of the company transfers. The buyer is similarly advantaged through lower up-front costs.

Sellers often ask for more attractive interest rates or a higher purchase price to offset the delayed payment or vulnerability to limited contractual protections. Acquirers might offer a portion of the company’s equity as dressing on the seller paper, which is particularly attractive for owner/CEO’s who want to remain in the game. However, few sellers would accept seller financing — even with relatively friendly terms — if a cash buyout is on the table.

In competitive bidding environments, acquirers use seller financing in their proposals to effectively inflate the headline value of their bids and simultaneously drive down the need for third-party financing.

There are risks, though. Some sellers might be looking for a large capital influx to invest in new ventures, in which case the prospect of seller paper might be too illiquid. Acquirers might be forced to accept higher interest payments, which could offset the benefits of leverage and drive down IRR. The prospect of a huge balloon payment might be intimidating, too.

When Seller Financing Makes Sense

Even though seller financing is most associated with private acquirers that may not be able to source enough capital without help from the target, Washko notes this isn’t always the case. “We have had a number of middle market transactions with strategic corporate buyers,” he points out, “that reach the finish line with some form of seller financing.”

In one deal, Washko saw seller financing as a complimentary tool to make both parties comfortable. “The corporate acquirer was concerned about two risks: the valuation depended on a high growth projection; and key customers might be lost with the exit of the current CEO/owner.” In other words, the acquirer needed some form of collateral and wanted to price the deal to compensate for the possibility of underperformance. Ultimately, the solution involved distributing the risk burden in a more equitable fashion.

“We proposed a combination of ongoing equity participation for the CEO, and an earn-out structured as a note paid on the realization of key growth metrics.” Washko indicated it was important for the acquirer to tie the price to future performance and for the seller to “accept risk by staying in with equity,” which “gave the acquirer a lot of confidence and reduced their immediate risk exposure.” Says Washko, this structure “was really critical in moving the deal to close.”