Owner financing–if you can get it–is one of the best ways to borrow money to buy a business, especially with how difficult it has become to get a start-up loan from a bank. Read this article to find out how owner financing works.
We wanted to revisit the issue of owner financing for one major reason: It might just be the last way (and best way) for a budding entrepreneur to purchase a business these days.
Face it – banks are not lending to those seeking to purchase a business and, to even get them to look at your deal, you better have two or three times the collateral in relation to the potential loan amount (regardless if the business is extremely profitable or not) – and just because they might look at your business loan request does not mean they will approve it. Even non-bank lenders are not lending for the purchase of a business unless it comes with a huge amount of real estate and then they will only fund based on a small loan-to-value of that real estate.
That leaves two options for most people wanting to buy the business of their dreams:
- Friends and Family (what some call Friends, Family or Fools). However, unless you have a very rich uncle, most of your friends and family are also facing financing restraints and either will not or cannot help you make a big purchase like buying a business.
- Owner financing. Where the current owner of the business is willing to sell it to you on terms (meaning they – not the bank – hold the note).
This is what we will discuss here, as this might really be the only way left to purchase a business today.
Owner financing can benefit the purchaser (you) in several ways:
- Easier to qualify for as you don’t have to jump through all the hoops that banks or lenders will make you jump through like cash flow analysis, property appraisals, debt-to-income ratios, personal financial statements, etc.
- Better terms than most banks will offer – thus, saving the new owner (the purchaser) both time and money – not to mention less in regards to reporting (ongoing financial statements and tax returns) and fewer covenants.
- More than just financing, since the current owner still has a stake in the business’s success, they will provide invaluable guidance and advice well into the future.
Plus, if the current business owner believes in the business (and you can get them to believe in you) – this should be a no brainer for the owner. If they hesitate without giving a very good reason, that might be a red flag to you as it might show that the current owner does not believe in the long-term viability of the business (they know something is wrong or in decline).
Let’s look at an example to show how owner financing works:
Let’s say you find a business for sale, a business that you know you will have the necessary passion to work hard at and grow beyond where it stands today. The price of the business is $100,000, yet, you tried to get a bank loan, a SBA loan and even a non-bank loan and have heard nothing but “NO.”
Here is where you approach the current business owner and entice them to sell you the business while carrying the note.
How your deal should work:
You tell the current owner that you will provide some down payment (this is to show good faith as well as provide a little cash incentive to the current owner). This down payment should be around 10% but could be less depending on how much you can raise. But, raising $10,000 is much easier than raising $100,000. Plus, any bank or non-bank lender would require you put up more than 10%, so 10% is really a win for you!
Now, if you put 10% down, that means the current owner would have to finance the remaining 90% or $90,000.
Here is how to approach that:
State that you will pay both principal and a comparable market interest rate (let’s say for this example – 10% APR) amortized over seven years (choose a term that makes the payments work for you as well as for the current owner). But, you will also include a balloon payment in three years, allowing the owner a full exit if necessary.
The longer term (7 years) gives you breathing room by making your payment affordable (the longer the term, the lower the payment). The balloon payment (meaning that even though the loan amortizes over 7 years, the remaining balance after 3 years will be due in full) gives the current owner a way out in a short period as well as provides you time (3 years) to establish yourself in the business. When the time does come, you have a track record that you can take to the bank to finance that balloon balance. Plus, if both of you are happy with the way things are going; you can always refinance the balance (balloon) with the current owner at the 3 year anniversary date.
Now, if agreed, you get the business (what you were working for to begin with). The current owner not only sells the business – but, given our example above, earns $22,700 in interest above the original purchase price – interest that you would have paid to the bank anyway if you were approved for a bank loan. Might as well pay it to the current owner.
From our example, your monthly payment would be around $1,500 a month – very affordable and at the 3 year balloon date. The remaining balance would be approximately $60,000 – much easier to get a loan approved for than the original $100,000.
In the end, you, as the new business owner are no worse off and now have bought yourself some time to show both the selling business owner and the banks that you are a true success.
The other side:
Why, you might ask, would a current business owner, looking to get out of the business, be willing to owner finance?
Two main reasons:
- The business owner, given this economy and the fact that banks are not lending, might not be able to sell the business any other way.
- The business owner benefits additionally as he/she receives not only the principal from the loan (what they wanted in the first place) but will also earn interest from the financing as your interest payments go to them and not the bank (e.g. major selling point).
In good times, for a business to succeed, the business owner has to be creative in all aspects of the business. In bad times, like now, to be a successful business owner, you have to get doubly creative, especially when it comes to financing.
If you have no other choice or options, it never hurts to go to the current owner and ask them to finance – what do you really have to lose? Just come prepare with a deal that benefits both you and the owner because owner financing just might be the best and last way to finance a business purchase today.