Owner-Carried Notes: What They Are & How They Can Be of Benefit
Many new business owners begin their new business by purchasing an existing enterprise or company from an existing small business owner. When starting a new business venture or trying to expand your existing business, the key is the level of capital (cash) that you will be required to raise to accomplish the new venture. Typically, the owner will inject their own internal capital partnered with a certain level of bank financing to facilitate the project. As detailed in my last blog, sometimes the business owner doesn’t have the necessary initial cash and needs to bring in partners to help finance his/her project. This can be done through venture capital loans or providing a percentage ownership from the partners.
However, there is another strategy that can be utilized that will “not require” dilution of ownership nor the high cost of venture capital financing for a new business. This strategy would be to negotiate a loan with the Seller of the existing enterprise to owner-carry a portion of the purchase price. When the Purchaser (“You”) injects their own personal cash and obtains bank financing, but this amount doesn’t cover the entire purchase, the Purchaser can negotiate paying the balance from the Seller through an owner-carried note. Why would the Seller do this? Many times, the Seller of a successful enterprise is selling due to retirement plans, no one to take over the business, or the desire to pursue other interests. If owner financing is not utilized, the Seller will realize 100% of the gains in that year and will be subject to being taxed the entire tax burden realized in that year. This tax effect on the Seller can be deferred significantly by providing an owner carried note. These notes are typically longer term in nature and provide the Purchaser with lower payments in the beginning (during the bank financing) with a more aggressive amortization later in time or a lump sum payment at maturity. The Purchaser benefits from the lower payments early on during the original bank financing and then has the opportunity to either accept the Seller’s stated remaining payment plan or obtain additional bank financing to pay off the Seller.
From a banking standpoint, the bank is usually able to have the Seller subordinate its payment to the bank’s loan. This is in consideration of the initial cash payment (“from you and the bank financing”) and the tax benefit to the Seller. Additionally, this strategy allows for lower payments in the early stages of the business and allows for flexibility in cash flow and building capital.
The benefits of an owner financing a portion of a business purchase or acquisition has proven successful benefits and results for both Purchasers and Sellers. It should be one of the many strategies that are considered in the start-up and/or expansion of your small business.