Hello Freedom Seekers!
I launched a poll last week to understand what people are most interested in learning more about…turns out its financing. Today, we are going to start breaking this down by starting with:
Some level-setting for folks that are totally new here
Seller financing
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Level-Setting
I think it’s worth it to level set on how this actually works in principle. When you are acquiring a business, you are going to be paying for it via a few different “sources” of “money.” Let’s use an example, say you are acquiring a business for $1 million. There are two ways you are going to pay for said business:
Debt
Equity
Debt | Equity | |
|---|---|---|
Get | Capital | Capital |
Give | Repayment Obligation | Ownership |
Cost Of Capital | Lower | Higher |
Preference | Higher | Lower |
It’s important to note that debt always has a lower of cost of capital and a higher preference than equity.
Lehman’s Terms: debt = less expensive and gets paid before equity
Within each, you then have internal & external as well as cash & non-cash:
Internal = leveraging your own capital. External = leveraging other people’s capital.
Cash = cash is exchanged as part of the transaction; non-cash = no cash exchanged as part of the transaction.
I think the only way this makes sense is to start illustrating a sources & uses table. Literally think of this as detailing “what you are buying” and “with what money”…you could think of this the same way you would for a grocery list (sources = credit card / cash in your wallet / debit card & uses = bread, milk, eggs, etc.). Same deal here →
So, in this scenario you have quite a few things going on…let’s tackle each
Seller Note: rather than have the bank lend you cash to pay the seller, the seller becomes the bank. So no exchange of cash, you just agree to repayment terms (payment schedule, interest, etc.) for the agreed upon amount.
Bank Financing: this is where you will hear terms such as “SBA financing”…there are many different terms & products here, but for starters, the main ones you need to be aware of are:
SBA 7(a): primary form of financing for small business acquisition; can borrow up to $5m; typical repayment schedule of 10 years
SBA 504: primarily designed for major fixed assets & commercial real estate (can be used in combination with 7(a))
SBA Express: faster turnaround time than standard loans, but has a strict cap of $500,000; often used as "gap" financing or for smaller business or franchise purchases, although the repayment terms are shorter (usually 5 to 7 years)
Down Payment: this is the payment you personally make at close, leveraging your own capital however, it is important to note, that this doesn’t need to necessarily be cash you have on hand. There are SO many ways to leverage your net worth without having to withdraw cash directly from your checking account. Such as:
Pledged Asset Line (my favorite, dirty little secret): borrowing against brokerage account
Home Equity Line of Credit: borrowing against home equity
ROBS: borrowing against 401(k)
Seller / Management Rollover: this is where the Seller (or Management) will “rollover” equity. So basically envision (for this example), that they are going to retain 10% of the Company. So, in this scenario, their “stake” is valued at $100,000 and serves as a non-cash “source” of capital. (I know this kind of a lot and somewhat oversimplified, but this is the easiest way to understand)
Friends & Family: this would exemplify the classic example of friends & family wanting to contribute to your business journey for a combined 10% equity stake in your business. Think of this as exemplifying really any external investor contributing capital in return for ownership in your company.
Need Help? Guys if you are serious about buying a small business, you NEED to ask for help and leverage others on this journey. Ideally those that have been there & done that. That is exactly why I created the Buying Freedom community. This was created out of 50+ conversations with active searchers. 7-day free trial. Free 1:1 strategy call with myself. Only $49/mo. Come get some →
Seller Notes (aka Seller Financing)
Seller financing catches a lot of heat because SO many gurus claim that it’s totally easy & doable to buy a business for like 80-100% seller financing. Those opportunities DO exist, but they are extremely few and far between…aka if your base case thesis for being able to successfully acquire a business rests on this financing strategy, you shouldn’t pursue this.
Why its powerful:
Reduces required upfront cash
Keeps seller “on the hook” and aligned with you for post-close success
How to Use & Present to Sellers:
IMO - you should always propose some sort of deferred consideration in every single structure for SMB acquisition. A Seller’s response to the proposal will often uncover an enormous amount of information that you wouldn’t have received otherwise.
For example, if you are acquiring an operation that is truly an absentee or semi-absentee owner, then by definition, if the owner changes, it shouldn’t affect the business that much and therefore they should be comfortable “holding paper” (aka doing seller financing).
I personally think the holy grail is a combination of seller financing + a performance-based “earnout”…this allows you to:
Offer a higher “sticker” price
Create a “carrot” for the Seller to chase post-close
Establish a (disguised) 0% tranche of seller financing
The way you should “use” this mechanism heavily depends on:
Deal size
Other available sources of capital
(Most importantly) The overall story: basically you need to use your brain here, few examples:
1/ If the Seller want to stay involved post-close, especially in a revenue-generating capacity, they should be willing to hold a decent amount of paper.
→ Tactic: Have Seller’s willingness to hold paper validate their financial forecast & ability to drive cash flow (if staying on post-close)
2/ If you can self-fund 30% of the purchase price, it’s not unreasonable to propose seller financing for the remaining 70% of the purchase price to avoid external forms of capital that could decrease the probability of close and/or introduce complexity…”Hey, instead of me getting a bank involved, what would you think about a 7-year, 6% note payable to you vs the bank?”
→ Tactic: Introduce transaction risk by bringing in external capital and associated requirements and processes
3/ If you can tell the Seller is solving for cash flow certainty (aka consistent, monthly cash flow) and/or a tax-advantaged sale, frame a Seller note as an optimal outcome as compared to a lump sum amount.
→ Tactic: Align your structure to achieve the Sellers’ ultimate goals in a business sale
Typical Target: as articulated above, your ultimate structure, is entirely specific to the individual deal. However, I’d say the common “rule of thumb” for your capital structure is 10-25%, with the “sweet spot” being 15-20%. 10% at a bare minimum. As far as rate goes, it’s really a case by case basis. Given the current rate environment, I’d go out of the gates with 5-6% and go from there.
SBA Intricacies: So, basically, the SBA 7(a) program is going to require a minimum 10% equity injection from the Buyer for an acquisition. Previous regulation allowed Seller notes to fully count towards this payment. So effectively, if you could negotiate a 10% Seller note, you could fund the rest of the deal with SBA financing and boom you just acquired a business for $0 down. Obviously, you can see why this would be problematic.
Now, a seller note can only count toward that equity injection if it's on full standby for the entire life of the SBA loan, and it can't exceed half of the required injection. So effectively up to 5% of the 10%. "Full standby" means no principal or interest payments are made during the loan term.
This doesn’t mean you can no longer use traditional seller financing (e.g., regular payments starting immediately or shortly after close), it just means that it no longer counts towards the equity math.
A practical structure people are using to preserve flexibility: one note on full standby that counts toward equity injection plus a second subordinated note on a shorter limited standby that sits outside the equity calculation but can be excluded from debt-service coverage analysis during underwriting.
In short, Seller notes are a highly tactical form of financing; however, I think their true power lies in what it reveals once proposed in an LOI. Even if you don’t intend to leverage the financing strategy, you should propose this solely as a diligence exercise, to observe how the Seller reacts. It always uncovers something.
What do you want to see next?
Have any thoughts or questions?
Want me to focus on something specific in an upcoming issue?
Let me know! Reply to this email, shoot me a direct note at [email protected] or connect & DM me on LinkedIn. I’d love to connect with each and every one of you to help in your journey.
~Mitch
