Let’s assume you are ready to sell your business and you are reviewing two competing offers, both compelling in their own way. The first offer is for an all-cash payment at closing for $1M (Option 1). The second offer is for $1M, but the buyer asks the seller to accept payment over the course of the next five years at an interest rate of 7% (Option 2). All other things being equal, which structure is best for the seller?
As Option 1 is straightforward, let’s consider the nuances of Option 2. Option 2 is in the form of an owner-carried contract, and it might present an interesting offer for the business owner. Often, business owners worry about how they might produce income once their income-producing baby (their business) is gone. In this case, the buyer offers a solution—making payments over time to allow Seller the cash flow to which he or she is accustomed.
There are several things that the seller should consider before settling on Option 2. First, why is the buyer using the seller for the loan when banks are in the business of making loans? Usually this is because the buyer is unable to obtain bank-financed lending on the terms proposed. If the buyer could get better terms from the bank, there would be no reason to have the seller carry the contract.
This suggests that a bank would charge more. The seller should consider this and plan to charge an interest rate higher than that offered by local banks for a similar transaction with similar security (collateral). Seller does not want to be in a position of offering financing below bank rates leading to the perverse economic incentive for the buyer to delay payoff. Seller would further want to ensure proper (and abundant) collateral from the buyer to ensure payments are made in a timely manner.
One big potential positive of Option 2 is the ability for the seller to treat the sale as an installment sale and thus spread out the gain from the sale over many years and reduce the overall tax burden to the seller. Because of the nature of installment sales, the seller would pay tax on a portion of the gains each year that payments are received (5 years in the example).
But, consider a couple important trade-offs. First, an installment sale means that the seller can’t rely on current income and capital gains rates. That is, if taxes go up, the seller would likewise be subject to potentially higher taxes in the future. It’s an important point – ask yourself, do you think taxes will go up in the future? The seller has the choice: lock in current tax rates now or claim installment sale treatment to pay the taxes over time as payments are received under the tax imposed at the time of receipt.
The second important tradeoff is the risk of non-payment. For most, this is the bigger issue. Assume in the transaction that the seller received excellent collateral (which is not always the case). Good collateral might include the business itself (stock or equipment or inventory being sold) as well as things like a mortgage on the buyer’s personal residence. Assume the buyer misses a payment. How much time goes by before the seller says something? How much time before the seller has to engage an attorney. How much time after engaging an attorney until payment is received or collateral is seized? How much will all this cost the seller? How important is prompt payment to the seller? The experience of having a buyer fail to make payment is emotionally devastating, as well as expensive and complex for the seller.
Ask your attorney for his or her thoughts. What experience do they have with buyers not making payments and what effect has that had on the seller? It happens, and it happens sometimes with the same buyer consistently failing to pay the amounts when due.
Although Option 2 offers the potential opportunity to lower taxes and maintain an income stream for the buyer, it is not without substantial risk. If a seller chooses Option 2, the buyer should charge interest at or above commercial banking rates. The seller should also make sure to obtain excellent collateral to seize in the event of non-payment. Finally, the seller should require a personal guarantee from the buyer (if buyer is a corporation) to be able to properly seek recompense from the personal net worth of the buyer’s owner.
Back to the original question – which deal should you choose? There is not necessarily a “correct” answer. But, given the uncertainty with Option 2, if it were my decision, I would choose Option 1. As the saying goes, “A bird in the hand….”
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The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
