Using a promissory note when you sell a small business

When you sell a small business and let the buyer pay part of the price over time, the buyer signs a seller note, a promissory note payable to you. The safest version is secured by the business assets, backed by the owners' personal guarantees, and written to fit any bank loan the buyer is also using.

How does seller financing work in a business sale?

The buyer pays part of the price at closing and owes you the rest under the note. You become a lender to the person running the business you built, so the note has to protect you if the business struggles.

Here's an example. You sell for $400,000. The buyer pays $100,000 at closing and signs a $300,000 installment note at 7% interest, paid monthly over five years. Each payment is about $5,940.36. Over 60 payments, the buyer pays about $356,421.57, which includes about $56,421.57 in interest.

How do you secure a seller note with the business assets?

Use a secured note and a separate security agreement that covers the equipment, inventory, accounts, and other assets you're selling. The security agreement gives you a lien. Filing makes that lien good against the buyer's other creditors.

Under the Uniform Commercial Code, a financing statement, usually called a UCC-1, must be filed to perfect most security interests. North Carolina's version, G.S. 25-9-310(a), is typical. The filing goes in the state where the debtor is located. Under the UCC rule in G.S. 25-9-307, a corporation or LLC formed under state law is located in its state of formation, and an individual is located at their principal residence.

If the buyer forms a new company to buy the business, file against that company in its state of formation. A filing under the wrong name or in the wrong state may leave you unperfected and behind other creditors.

Run a lien search on the buyer before closing, too. If a bank or equipment lender already has a filing against the buyer's company, you'll need an agreement on who gets paid first from which assets. Settle that in writing before any money changes hands.

Should the buyer personally guarantee the note?

Yes, in most cases. Buyers often form an LLC or corporation to take over the business. If the company signs the note alone and fails, you can usually collect only from the company's assets.

A personal guarantee from each owner gives you a second source of payment. Ask for the guarantee in a separate signed document, and make sure it covers the note, interest, and your collection costs. If the buyer's spouse co-owns the company, ask for a guarantee from the spouse as well.

What happens when the buyer also has an SBA loan?

Many buyers fund the rest of the price with a 7(a) loan backed by the Small Business Administration (SBA). SBA lenders follow the agency's lending rulebook, SOP 50 10, and it controls how your note fits in.

Under SOP 50 10, seller debt can count toward the buyer's required equity only if it's subordinated to the SBA lender and on full standby. Full standby means no payments of principal or interest for the term of the 7(a) loan. Interest may accrue and be paid after the 7(a) loan is paid off.

The lender must use SBA Form 155 or an equivalent standby agreement, with a copy of your note attached. As the standby creditor, you must subordinate your lien rights in the collateral and take no action against the borrower or the collateral without the lender's consent. Seller debt that isn't on full standby still has to be supported by the business's cash flow. Read the standby agreement before you sign the purchase contract, because it can delay your payments for years.

How is a seller note taxed?

The Internal Revenue Service (IRS) treats a sale as an installment sale when you receive at least one payment after the tax year of the sale. Under Topic 705, you report the gain under the installment method unless you elect out, and you file Form 6252 for the year of sale and each later year of the note.

A business sale needs extra care. IRS Publication 537 says the sale of an entire business for one price isn't the sale of a single asset. You allocate the price among the assets, and both buyer and seller report the allocation on Form 8594. Gain on inventory can't use the installment method, and any gain that is depreciation recapture is ordinary income in the year of sale, even if you collect the cash later.

Interest the buyer pays you is ordinary income. If the note charges little or no interest, Publication 537 warns that you may have to figure unstated interest or original issue discount.

Publication 537 also covers what happens later in the life of the note. Selling the note, canceling it, forgiving part of the buyer's debt, or repossessing the assets can each trigger gain or loss. Talk with your tax preparer before you change the note's terms after closing.

What terms belong in a seller note for a business sale?

Start with the rate. Some states treat business loans more loosely. Illinois exempts business loans from its 9% cap under 815 ILCS 205/4, and New York bars corporations from raising civil usury under General Obligations Law 5-521. Check your state with our usury limit checker.

Then set the payment schedule. A five-year term with monthly payments, like the example above, is easy for both sides to track. Some sellers ask for a balloon payment at the end so the buyer can refinance with a bank once the business has a track record under new ownership.

Next, define default broadly. Include missed payments, the buyer's bankruptcy, a sale of the business or its key assets, and a failure to keep insurance. Add an acceleration clause, a reasonable late fee, and a right to receive the business's financial statements each year.

Finally, expect the buyer to ask for a right of offset, which lets them reduce payments if your sale promises turn out to be false. If you agree, limit it to claims that are finally resolved, so the buyer can't stop paying over a dispute.

Sources

• SBA SOP 50 10, Lender and Development Company Loan Programs
• IRS Topic 705, Installment Sales
• IRS Publication 537, Installment Sales
• N.C. G.S. 25-9-310
• N.C. G.S. 25-9-307
• 815 ILCS 205/4
• N.Y. General Obligations Law 5-521