SELLER FINANCING: WHAT YOU NEED TO KNOW
The Lender of Last Resort
Trying to sell or buy a business or commercial real estate? If you are the biggest obstacle you will encounter is financing. Tough new rules govern bank lending in the wake of the 2008 economic collapse. Banks face greater government scrutiny than ever before and have become more restrictive in giving loans. Further, the documentation requirements and due diligence banks must perform to issue a loan have increased significantly.
These facts of life frustrate people trying to buy or sell a business or commercial real estate. There are very few cash deals out there. This is why I am seeing more and more so-called 'seller financing' transactions.
Seller financing is the last resort when banks either refuse to give a loan for a particular transaction or don't agree to finance the full sale price. The seller holds paper and acts like a bank.
Risk to the Seller
From the point of view of sellers this type of financing is risky business. Banks manage the risk of their many loans, insure against uncollectible loans, and have the economic strength to absorb losses if and when they occur. Banks benefit from the law of large numbers. Not so with an individual seller who agrees to finance a single loan.
I tell all my clients who consider seller financing to evaluate risk. Who is the buyer and what is his credit worthiness? Be aware and beware of the reputation of the buyer (which you can check out for free on so-called reputation score websites like Mylife.com.) What if the buyer has a good credit score, good collateral and a bad character?
Risk to the Buyer
Buyers face risk too. What if the seller has a great property and a lousy character? (Again, check the person out on a free reputation score website such as Mylife.com.) As a CPA experienced in advanced valuation concepts I could discuss this problem in great technical detail. But here is the bottom line in plain English:
Good property in dirty hands is worth less money
It doesn't matter if the seller has a great property, you really want it, and he's willing to give you seller financing. If the seller has a police record and a long history of being sued by victims he tried to cheat then any property he sells you is worth less money because you don't know what you don't know. Are there undisclosed environmental liabilities? Asbestos? Hidden explosives? Did the seller bury some of his victims there?
Knowledge is power because it helps us avoid risk.
What Rate to Charge?
When it comes to interest sellers should charge a significantly higher rate because of the risk they are exposing themselves to. Banks, because they are big and financially sophisticated, can charge market interest rates for a transaction. Private sellers on the other hand must charge much more. When clients ask me what rate they should charge on a seller financed transaction I always say "double digit." Always charge at least 10% or more based on the details of the transaction. If you are not a bank but act like a bank then you must think like a bank: The interest rate charged for a seller financed deal must be based on risk.
You Must Charge Interest
I've seen seller financed transactions where both parties want an interest free deal. The IRS does not allow this if the total loan amount exceeds $10,000. You must charge at least the minimum interest rate prescribed by the IRS. This minimum rate is called the "Applicable Federal Rate" ("AFR") and is updated monthly. There are actually three AFR's: (1) short term loans that are paid off in three years or less; (2) mid-term loans paid off in nine years but more than three years; (3) long term loans paid off over nine years.
Charging interest does not mean you must charge more. For example, assume a buyer and seller agree on a $100,000 sale price and are subsequently told by their accountant that they must charge interest. This surprises them and the buyer worries he will have to pay extra. THIS IS NOT TRUE.
In this simplified example the deal can be altered to comply with the IRS requirement to charge interest without increasing the total amount paid. This can be achieved by calculating what is called the imputed principal amount. A $100,000 deal with a ten year loan payment schedule that is closed in June, 2018 requires a minimum IRS interest rate of 3.02% (assuming monthly payments.) The imputed principal in this case is $86,218 and the total required interest is $13,782. The total amount paid remains locked at $100,000 (86218 + 13782 = 100000) and the IRS is happy.
Sellers: Protect Yourself
If you are the seller in a seller financed transaction and are selling real estate I recommend keeping the title until the buyer pays in full. This is a protective measure that offers the greatest degree of loan collateralization. However, as a buyer nears the end of paying a loan he may want the title prior to payoff. If the seller keeps the title until loan payoff the buyer and seller should agree on how to handle property insurance.
Buyer's: Beware of Prepayment Penalties
Buyers turn to seller financing usually because they can't obtain a traditional bank loan, or the bank won't lend enough to cover the sale price. As time goes by and a buyer pays down the loan he may become financially stronger while (perhaps) building equity in the property. A point may come when the buyer doesn't need a costly seller-financed deal and will want to refinance with a bank at a lower rate. Watch out for prepayment fees!
Banks Don't Lend on Intangible Assets
Because of tougher lending standards banks are generally not allowed to give loans collateralized by intangible assets. If you are trying to sell your business be aware that banks will not finance the buyer for goodwill. Goodwill is the financial value of a good business reputation and is usually built up over many years of taking good care of customers. The reason banks won't consider goodwill is because they can't physically seize it in case of default. If goodwill is a substantial portion of the sale price it is almost certainly the case that seller financing will be needed to bridge the gap between what a bank will lend and what a seller wants for his sales price.
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339
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