How Does Owner Financing Work With Small Business Acquisitions?

Acquiring a small business lets new entrepreneurs own a business without starting from scratch. But picture this. 

An aspiring business owner needs to buy a business and can’t access a traditional bank loan because banks don’t deem them creditworthy. Their credit score is low, and they have no collateral. 

On the other side of the deal is an owner ready to sell their business and pursue other interests. However, most deals fall through because interested buyers cannot raise the money they’re asking for, disrupting their exit plans. 

The silver lining? Owner financing can solve both parties’ challenges. So, how does owner financing work in a small business acquisition? We explain everything you need to know in the article below. 

What Is Owner Financing?

Owner financing, or seller financing, is a structured acquisition plan in which the seller becomes the lender and affords the buyer flexible payment terms. This eliminates the need for the buyer to rely on traditional institutions for funding and allows the seller to attract more buyers. 

Instead of seeking funding from a traditional bank, the parties negotiate terms, including the sale price, financing terms, and down payment. They write these terms down on a promissory note, which is a legally binding document. 

The buyer then makes a down payment and pays the remaining amount to the seller in installments. This allows them to spread out payments over time and lowers their upfront costs. 

How Does Owner Financing Work?

Owner financing involves several steps that allow the parties to structure the deal, set fair terms, and confidently navigate the acquisition. 

Understanding the owner financing process lets buyers and sellers negotiate favorable agreement terms. These terms shield them from potential risks and make the process more transparent. 

Here is how owner financing works and the steps involved in the process: 

Step 1: Negotiating the Sale Terms Price

The process begins with the buyer and the seller negotiating a fair purchase price. They then set a suitable down payment depending on the buyer’s financial situation and the seller's preferences. 

Traditional banks demand a 10% - 20% down payment, depending on a buyer’s creditworthiness. With owner financing, a buyer can negotiate a more favorable down payment to save money for operations or inventory.

Step 2: Establishing the Repayment Structure

After agreeing on a down payment, the parties define how the buyer will repay the remaining amount. They create a structure detailing the frequency and amounts of payment. 

This structure may include the following:

• Amortized loans: These loans have fixed monthly payments, and buyers follow a predefined schedule to pay off the principal and interest.

• Balloon payments: These are smaller monthly payments with a larger lump-sum payment due at the end of the loan term.

• Interest-only periods: The buyer pays only interest for a set time before switching to principal and interest payments.

Step 3: Setting the Interest Rate and Loan Duration

In the third step, the parties negotiate an interest rate that reflects the cost of borrowing. They also agree on the loan term, which varies depending on the seller's risk tolerance and the buyer’s financial capacity. 

It’s important to note that owner-financed deals have higher interest rates than traditional bank loans because they pose a higher risk to sellers. 

Step 4: Drafting the Legal Agreement

After agreeing on the terms, parties create a legally binding promissory note and security agreement. These documents outline repayment schedules, interest rates, default clauses, and collateral arrangements, helping prevent disagreements later on.

Risks and Benefits of Owner Financing for Buyers and Sellers

Owner financing has benefits and risks for both buyers and sellers. Weighing them helps the involved parties make decisions that align with their goals. These decisions can be as simple as adding clauses in their agreement terms to cushion them against the risks. 

We’ve compiled the benefits and risks for both parties to help you understand where seller financing can work in your favor and the risks involved. 

Benefits and Risks for Buyers

Seller financing provides an alternative source of funding to traditional banks. This helps buyers bypass strict bank requirements, such as perfect credit scores. 

It also eliminates the need for third-party financial institutions, allowing buyers to negotiate flexible deals that suit their economic capacity.

That said, this financing option does come with some risks for buyers. First, its interest rates are higher than the rates banks offer, making it a more expensive alternative in the long run. 

Limited legal protection also exposes buyers to vulnerabilities, such as limited consumer protection, which might lead to predatory terms. Baton helps buyers minimize the risk of predatory terms with vetted listings of safe-to-acquire businesses that we’ve evaluated.

Lastly, most owner-financed agreements allow the seller to quickly reclaim the business, assets, or collateral in case of missed payments. This leads to a financial loss of the payments the buyer has already made. 

Benefits and Risks for Sellers

Owner financing attracts more interested buyers by including those who don’t qualify for traditional bank loans. This creates competition and increases the chances of selling faster. 

Seller financing faces fewer regulatory hurdles than traditional lending. This minimizes paperwork and gives sellers more negotiating power to secure higher sales prices. Additionally, they earn interest on the financed amount, increasing overall profitability. 

Depending on the terms they negotiate, sellers also retain legal rights over the business as collateral until full repayment, cushioning them against default. 

However, they still face the risk of default if the buyer fails to make payments, which leads to losses. Also, due diligence on potential buyers is time-consuming and might consume the seller’s resources. 

Baton offers guidance on structuring deals to balance buyer and seller goals, helping both parties avoid unfavorable terms. We also use different validation methods to give sellers accurate values of their companies so they get a fair market price. Our expert guidance and support can also help reduce unforeseen issues, making acquisitions safe for all parties. 

Simplifying Business Acquisitions With Owner Financing

Owner financing presents a unique opportunity for buyers and sellers to complete a business acquisition without the barriers of traditional bank lending. It gives buyers access to secure funding even without a strong credit history or collateral.  

It exposes sellers to more buyers, enabling faster sales and allowing them to command a higher purchase price. 

Looking to buy or sell a business with minimal risks? Baton enhances acquisitions by pre-qualifying buyers and providing transaction support, making each deal safe. 

Talk to us about buying or selling today.