What is seller side financing?
Seller side financing is a useful tool that allows buyers to purchase a company putting little or no capital down out-of-pocket. It's useful when buyers want to make deals that require more capital than they either have available or are willing to use.
How does it work?
The essence of seller side financing is instead of paying for the company with your cash up-front, you use the recurring revenue of the business to pay the seller in monthly instalments. In return for this, the buyer will pay a higher fee for the company once all the payments are completed.
You can think of this as the seller loaning the buyer the money for the company with a set interest rate.
Let's say we have a company that is for sale:
- MRR: $6k
- Monthly profit: $5k
- Company valuation: $100k (at a 1.67x multiple of yearly profit)
A repayment structure might look something like this:
Monthly repayments to the seller: $7k/month * 16 months = $112k
Here, the buyer is using the $5k/month profit from the company to repay the seller, adding an extra $2k/month form their own pocket. In total the seller will receive $112k, making a 12% rate of return on the capital they "loaned" the buyer.
The numbers above assume no growth of the company over the 16 months, with growth the buyer will pay less each month out-of-pocket.
Of course you can also play with these numbers to ensure the buyer pays nothing out of pocket each month but pays more months, this could lead to the seller asking for a higher rate of return.
What are the risks?
Obviously this method comes with risks. If the profit of the business declines and the buyer doesn't have the capital available to maintain the monthly payments then the seller is left with the short end of the stick.
For this reason there is often a clause in the asset purchase agreement that states if the buyer misses a specified amount of payments then the business and its assets are returned to the seller, often without refund of the money already paid.
This puts the risk in the buyers court and would make the seller more likely to agree.