What is owner financing?
Also called seller or vendor financing, owner financing is a 'creative' way of financing the sale of real estate or businesses.
Instead of borrowing all the capital from a bank or other finance provider, the buyer borrows all or part of the sale price from the seller. They then repay the loan in instalments over a fixed period.
The terms of the loan are documented in a 'loan note', otherwise known as a promissory or carry-back note.
The buyer generally makes a down payment, while the business itself serves as collateral. So if the buyer defaults on payments, perhaps because the business isn't making enough money to service the loan, the owner takes back control of the business.
Every sale is different. Interest rates, repayment duration and other factors can vary from deal to deal.
When is owner financing a good idea?
As one broker put it: "Before the credit crunch, the banks would lend to anyone who could read and write. It was easy then, but everything's changed in finance now."
Banks are reluctant to lend to each other, let alone entrepreneurs, and the number of loans backed by the Small Business Administration has plummeted in recent months. Even private equity firms, which are usually unafraid of risk so long as the potential returns are high, are being circumspect.
Owner financing can rescue deals from collapse in the increasingly common absence of other sources of funding.
Admittedly, business buyers are finding it easier to raise finance than start-up entrepreneurs, because less risk is attached to an established enterprise with a track record and accounting history. Nevertheless, buyers are still encountering unprecedented intransigence from banks.
"In America, 70% of businesses for sale don't sell," observes another broker. "And the reasons are the price expected is too high, the buyer can't raise the money or seller financing is not taken up as an option."
If a business has an unimpressive profit history; if it's in an industry that is ultra-competitive, subject to soaring operating costs or susceptible to recession; if you have no experience in the sector or in running businesses generally; if you have any history of adverse credit; if you're unable to put down a big down payment - anything about you or your target business that ratchets up the perceived risk is going to make it difficult to obtain credit through the usual channels.
So presumably owner financing is becoming more widespread?
Seller financing is already a well established means of financing deals in the US, certainly more so than Europe, which is culturally more risk-averse.
But yes, with credit lines still blocked up, it is a more common funding tool than ever.
"In today's environment," says Tony Calvacca, owner of New York Business Brokerage, "no lenders that we're aware of will do any lending without having the seller participate, no matter how good the deal is, because of the stress in the market."
Across the economy, from small businesses through the mid market to large corporates, owner financing is a regular way of financing business sales. But down on Main Street, debt funding through loan notes is often imperative.
"There's a direct correlation between the size of the transaction and whether it will be seller financed or not.
"Because most small retail, Main Street businesses take a lot of cash, they'll typically not show many sales on their tax returns, so their financials cannot be used to substantiate lending. Therefore a high majority are 100% seller financed, because there's just no alternative."
"If you're talking about larger transactions, upper main street or low mid-market deals, then there is almost always some degree of seller participation, but they're usually not totally seller financed.
Is it particularly popular in certain sectors?
Owner financing is particularly popular with businesses whose value derives more from intangibles, such as brand, goodwill, client relationships, and the knowledge and skill of staff, than physical assets such as the premises or equipment.
This is because it's often difficult to illustrate to banks how you arrived at a given value for your business; only you, with your day-to-day, intimate experience within the business, can truly appreciate the business's merits, which are difficult to convey to banks.
Owner financing is often employed by management teams that buy out businesses because they, more than any other prospective buyer, appreciate and understand the value of the customers, staff and brand.
Calvacca says that "professional practices, such as dental practices, CPA firms, medical practices and insurance agencies lend themselves very well to seller financing." This is because their worth is largely measured in the quality of its staff and its reputation.
But even if valuing professional practices isn't easy, Calvacca says that "many lenders are very eager to lend to those types of practices because they are viewed as much less risky.
"If you have a professional with a clearly defined skill set, so he's prepared to make that practice successful, then, the seller will expect, and reasonable should expect, that the vast majority of the deal is not going to be financed by the seller, and that's a positive with those industries."
By contrast, the merits of the dating agency Roland Stringer tried to acquire were more difficult to convey to banks. Also difficult to value, it was ideally suited to owner financing.
"There isn't much in the way of assets," Stringer explains. "The value is in the 15,000 lifetime members. It's therefore quite hard to raise money on and, secondly, we wanted to make sure the vendor remained supportive."
How does owner financing ensure the support of the vendor post-sale?
Find out this and other benefits of owner financing in the second instalment of the owner financing series.