Bank Financing vs. Seller Financing: What Business Buyers Need to Know

When a person is ready to purchase a business, the first thing they should recognize is that the issue of funding comes about very shortly thereafter. Essentially, there are two avenues: 1) bank financing and 2) seller financing (let's say the current owner agrees to finance part of the transaction without going to a bank). They play out differently, cost different amounts, and each one has associated frustrations and benefits.

Yet what's most interesting is that purchasers fail to realize how these options impact everything else surrounding a transaction. From timelines to which forms get sent in to how the business purchase price gets negotiated, there are significant differences.

Here's what matters most when it comes to these two options.

How Banks View Purchase Loans

Banks generally have different views on business purchase loans than they do regular business loans. They want to ensure that the business being purchased has enough cash flow to not only pay for the principal amount but also provide an owner salary to the new owner. Therefore, the math must work, and banks become very specific about the details.

Banks take time to apply for. From application to funding, expect 45-90 days or more during the process as additional conditions might be requested if purchased businesses have complex financials or are located in industries deemed high risk (trucking, construction, etc.). Buyers need three years of tax returns and profit and loss statements, personal disclosure for financing, and a detailed operational plan of how they will run the company once in charge.

Generally, banks will finance 70-90% of the purchase price depending upon business assets and balance sheets as long as it makes sense financially. Relative to other financing options, interest rates are lower, which lends itself to equity growth over time. However, the barriers to entry with bank financing are much higher; buyers must have reasonable credit scores, industry experience and additional operating cash reserves beyond their anticipated down payments.

When Is Seller Financing Appropriate?

Seller financing occurs when a buyer negotiates (intentionally or unintentionally) with a seller to allow them to pay for the business incrementally over a 3–10-year period. This essentially creates a promissory note that will have monthly payments from buyer to seller.

The big advantage? Speed and flexibility. Deals structured with seller financing can close in weeks instead of months. There's less paperwork, fewer hoops to jump through, and the terms can be negotiated directly between buyer and seller. Selling a business to employees often involves this type of arrangement since internal buyers may not qualify for traditional bank financing, but have proven their capability to run the operation.

Sellers benefit from being compensated immediately upon payment; they can receive a better price over time by implementing seller financing as an option; interest payments during retirement provide cash flow. However, sellers are taking a risk, if payments are missed or if the buyer runs the business into the ground, it could end up back in their hands in worse shape than what it was sold.

The Truth About Cost Comparison

Generally, banks provide lower interest rates based on their current offerings (generally between 6-10% based on market value and individual qualifiers). Seller financing generally runs higher (8-12% or greater) since it's not being done through a bank who pays employees, rent and utilities, and sellers are higher risk since they're assuming costs without underwriting background.

However, interest rate comparison isn't what's most important. Banks generally come with origination fees, evaluation payment assessments, legal payments and more; this could amount to thousands of additional dollars required by buyers before cashing out. Seller financing eliminates these costs for the most part since they are essentially evaluated by the seller based on what they want, even if it's a higher interest rate percentage.

Furthermore, the time value of money is important to acknowledge. Seller financing means purchasers will be paying sellers over time; bank financing means money is put in sellers' hands essentially at once. Therefore, if sellers need cash now for retirement or new investments, even at a discounted sale price, banks work better, but since payment won't happen immediately, sellers might get a better deal with seller financing despite paying more.

Compromise: The Combined Approach

Many successful transactions occur through a combined structure, i.e., bank financing covers 80% and seller finances 10-20% depending upon the situation. This structure appeases everyone's apprehensions.

For example, if sellers finance a portion of the business deal, banks see that as a positive development. It shows seller confidence within the business and new entrepreneur as well as reduces bank risk exposure. For borderline applications that require additional positives, a seller note can sway approval. 

Buyers access bank financing perks relative to lower interest rates while accessing owner financed benefits regarding flexible terms. Sellers receive immediate compensation while keeping skin in the game for subsequent revenue should anything go wrong.

The terms matter, however; generally, with blended arrangements, the bank loan gets paid first and in priority status, the seller note is subjugated, in case anything goes awry.

Understanding What Makes Sense

Ultimately, both options make sense in certain situations. When buyers possess strong credit scores, relevant experience and additional cash reserves (beyond minimum down payments), it makes sense for them to pursue bank financing to access lower interest rates.

If buyers need speed (i.e., are family members or employees who know inherently they can run a business), if they're purchasing from other family members or current employers with whom they have longstanding relationships but might have precarious credit challenges or work history for loans outside of personal situations, seller financing could be the way to go.

In addition, certain businesses matter more than others. Banks look for established companies with solidified assets and customer bases whereas newer companies and those with unstable prospects might only qualify for seller financing through an established relationship.

Regardless of what buyers ultimately choose as the proper financing after proper assessment helps secure transactions that close and puts new owners in better positions moving forward once they take charge of operations.