Owner Financing vs Traditional Loans

"Should I get a bank loan or ask the seller to finance the purchase?"

It's one of the first questions business buyers ask—and the answer isn't simple. Both have significant advantages and disadvantages.

Here's everything you need to know to make the right financing decision for your situation.

## What is Owner Financing?

**Owner financing (seller financing):** The seller acts as the bank. Instead of you paying all cash at closing, you make payments to the seller over time.

**Typical structure:**
- Down payment: 20-40% of purchase price
- Remaining balance: Paid over 3-7 years
- Interest rate: 4-8%
- Monthly payments: Based on amortization schedule
- Often includes personal guarantee

**Example:**
- Purchase price: $500,000
- Down payment: $150,000 (30%)
- Seller note: $350,000 at 6% over 5 years
- Monthly payment: $6,761

## Traditional Bank Financing

**SBA 7(a) loan (most common for business acquisitions):**
- Loan amount: Up to $5 million
- Down payment: Typically 10% (but can be higher)
- Interest rate: Current SBA rates (typically 8-11%)
- Term: Up to 10 years
- Collateral: Business assets + personal guarantee
- Approval time: 60-90 days

**Example:**
- Purchase price: $500,000
- Down payment: $50,000 (10%)
- SBA loan: $450,000 at 9% over 10 years
- Monthly payment: $5,700

## Side-by-Side Comparison

### Initial Capital Required

**Owner Financing:**
- Down payment: 20-40% typically
- Closing costs: Lower (no bank fees)
- Total cash needed: $100,000-$200,000 (on $500K purchase)

**Bank Financing:**
- Down payment: 10-20% typically
- Closing costs: Higher (bank fees, appraisals, etc.)
- Total cash needed: $60,000-$120,000 (on $500K purchase)

**Winner:** Bank financing requires less initial capital

### Approval Process

**Owner Financing:**
- Speed: As fast as you can agree on terms
- Requirements: Seller decides (usually less stringent)
- Credit: Important but flexible
- Timeline: Can close in 30 days or less

**Bank Financing:**
- Speed: 60-90 days typical
- Requirements: Strict SBA guidelines
- Credit: Need good credit (typically 680+ FICO)
- Timeline: Minimum 60 days, often longer

**Winner:** Owner financing is much faster

### Interest Rates

**Owner Financing:**
- Rate: 4-8% typical
- Negotiable: Yes
- Tax deductible: Yes
- Current market: Often lower than bank rates

**Bank Financing:**
- Rate: 8-11% (current SBA rates)
- Negotiable: No
- Tax deductible: Yes
- Tied to prime rate: Fluctuates

**Winner:** Owner financing often has lower rates

### Seller Motivation

**Owner Financing:**
- Shows seller confidence in business
- Seller invested in your success
- Easier to get seller support during transition
- Seller has incentive to provide accurate information

**Bank Financing:**
- Seller gets all cash at closing
- Seller has no ongoing involvement
- Less motivated to ensure smooth transition
- More likely to move on quickly

**Winner:** Owner financing aligns incentives better

### Approval Criteria

**Owner Financing:**
Seller considers:
- Your experience and skills
- Your plan for the business
- Your character and trustworthiness
- Your down payment size

**Bank Financing:**
Bank requires:
- Good personal credit (680+ typically)
- Industry experience (preferred)
- Strong business financial history
- Collateral coverage
- Detailed business plan
- Personal financial strength

**Winner:** Owner financing is more flexible

### Risk to Seller

**Owner Financing:**
High risk:
- Gets paid over time (not immediately)
- Dependent on your success
- If business fails, may not get paid
- May get business back in worse condition

**Bank Financing:**
No risk:
- Gets all cash at closing
- Clean exit
- No ongoing involvement
- Bank bears all the risk

**Why this matters:** Sellers prefer bank financing, which gives you negotiating leverage with owner financing

## When Owner Financing Makes Sense

### For the Buyer:

✅ **You have limited capital**
- Can't come up with 20% down for bank
- Want to conserve cash for operations
- Need lower monthly payments

✅ **You don't qualify for bank financing**
- Credit issues
- Limited industry experience
- Business doesn't meet bank criteria

✅ **You want to close quickly**
- Competitive situation
- Time-sensitive opportunity
- Want to avoid 90-day bank process

✅ **You want seller involvement**
- Value seller's ongoing consultation
- Want seller invested in your success
- Need transition support

### For the Seller:

✅ **Seller can't find a bank-qualified buyer**
- Business doesn't meet SBA criteria
- Small business/low profit
- Asset-light business

✅ **Seller wants ongoing income**
- Doesn't need all cash now
- Wants to spread out tax liability
- Prefers monthly income to lump sum

✅ **Seller is confident in business**
- Strong business performance
- Loyal customer base
- Good growth prospects

✅ **Seller wants tax benefits**
- Installment sale treatment
- Spreads capital gains over multiple years
- Potentially lower overall tax bill

## When Bank Financing Makes Sense

### For the Buyer:

✅ **You can qualify for a loan**
- Good credit (680+)
- Industry experience
- Strong personal finances

✅ **You want a lower down payment**
- SBA requires as little as 10%
- Conserve cash for business operations
- Less capital tied up in acquisition

✅ **You want the seller out**
- Don't want ongoing seller involvement
- Prefer clean break
- Want full control immediately

✅ **You can get favorable terms**
- Lower interest rate from bank
- Longer repayment period (10 years vs. 5)
- Lower monthly payments

### For the Seller:

✅ **Seller wants all cash immediately**
- Needs money for retirement
- Wants clean exit
- Has other investment opportunities
- Doesn't want ongoing risk

✅ **Seller isn't confident about future**
- Uncertain market conditions
- Industry headwinds
- Competitive threats

## Hybrid Approach (Often Best)

**Many deals use both:**

**Example Structure:**
- Purchase price: $500,000
- Bank SBA loan: $350,000 (70%)
- Seller note: $100,000 (20%)
- Your down payment: $50,000 (10%)

**Why this works:**
- Seller gets most cash at closing ($350K)
- You put less down (10% vs. 20-30%)
- Seller financing shows seller confidence (helps bank approval)
- Seller still motivated to ensure smooth transition
- Often best of both worlds

**Typical hybrid terms:**
- Seller note: Subordinated to bank loan
- Seller note: Balloon payment after 2-3 years
- Lower seller note interest rate (3-5%)

## Negotiating Owner Financing

### Key Terms to Negotiate:

**1. Down Payment**
- Seller wants: 30-40%
- You want: 10-20%
- Typical: 20-30%

**2. Interest Rate**
- Seller wants: 7-9%
- You want: 4-5%
- Typical: 5-7%

**3. Term Length**
- Seller wants: 3-5 years
- You want: 7-10 years
- Typical: 5 years

**4. Amortization**
- Fully amortizing: Paid off at end of term
- Balloon payment: Large payment due at end
- Typical: 5-year balloon on 10-year amortization

**5. Collateral**
- Seller wants: Business assets + personal guarantee
- You want: Business assets only
- Typical: Business assets + limited personal guarantee

**6. Standby Period**
- You want: No payments for 3-6 months
- Seller wants: Immediate payments
- Compromise: 60-90 day delay

### Negotiation Strategies:

**Trade-offs that work:**
- Higher interest rate → Lower down payment
- Shorter term → Lower interest rate
- Larger down payment → No personal guarantee
- Full recourse → Lower rate

## Structuring the Deal

### Owner Financing Documents:

**1. Promissory Note**
- Amount borrowed
- Interest rate
- Payment schedule
- Default terms
- Prepayment terms

**2. Security Agreement**
- Collateral pledged
- UCC-1 filing
- Default remedies
- Seller's rights if you default

**3. Personal Guarantee (maybe)**
- Your personal liability
- Spouse may need to sign
- Limited vs. unlimited guarantee

**4. Subordination Agreement (if bank involved)**
- Bank loan has priority
- Seller financing is secondary
- Seller can't force default while bank loan current

## Risks and Protections

### Risks to Buyer:

**If business fails:**
- You lose your down payment
- Still owe seller the note
- Seller can seize business assets
- Personal guarantee means personal liability

**Protections:**
- Negotiate limited personal guarantee
- Shorter note term
- Right to return business if seller misrepresented
- Earn-out provisions based on performance

### Risks to Seller:

**If buyer fails:**
- May not receive full payment
- May get business back in worse condition
- May need to operate business again
- Legal costs to recover

**Protections:**
- Large down payment
- Personal guarantee
- First lien on all business assets
- Monthly financial reporting requirements
- Right to cure defaults

## Tax Implications

### For Buyer:

✅ **Interest is tax deductible**
- Reduces your effective interest rate
- Same whether bank or owner financing

✅ **Allocate purchase price properly**
- Maximize depreciation
- Minimize goodwill (not deductible)

### For Seller:

✅ **Installment sale treatment**
- Spread capital gains over payment period
- Pay tax as you receive money
- Lower overall tax in many cases

✅ **Interest income is taxable**
- Taxed as ordinary income
- Reduces benefit of capital gains treatment

**Important:** Both parties should consult tax advisors

## Red Flags

### Avoid deals where:

❌ **Seller is desperate to seller-finance**
- May indicate business problems
- Seller knows it won't get bank approval
- Business may be unsellable for good reason

❌ **Seller demands very short term (under 3 years)**
- Suggests seller doesn't believe in business future
- Creates dangerous cash flow pressure

❌ **Seller won't provide personal guarantee on transition**
- Shows lack of confidence
- Creates adverse selection problem

❌ **Terms are significantly worse than bank financing**
- Higher rate + larger down payment = bad deal
- Consider bank financing instead

## The Bottom Line

**Neither option is universally better:**

**Choose owner financing if:**
✅ Limited capital available
✅ Don't qualify for bank loan
✅ Want faster closing
✅ Value seller's ongoing involvement
✅ Can negotiate favorable terms

**Choose bank financing if:**
✅ You can qualify
✅ Want lowest down payment
✅ Want clean break from seller
✅ Prefer institutional relationship
✅ Can handle longer process

**Best approach:**
Understand both options, negotiate the best possible terms, and structure the deal that works best for YOUR situation.

**Remember:**
- Financing terms directly impact your cash flow
- Monthly payments affect business viability
- Down payment size affects your cash reserves
- Don't just focus on interest rate—look at total deal structure

Want help analyzing your financing options? Our Financial Analysis Template includes cash flow projections for different financing scenarios.