Sometimes the best-looking part of a deal is hiding the biggest problem.
A while back, a buyer came to an Acquisition Lab strategy call pretty excited about a pool-installation business he was looking at.
The seller wanted $4 million but was willing to finance half, offering him a $2 million seller note.
It was a substantial offer, and I could see why he was excited. However, when I started looking at the numbers, it turns out it wasn’t as generous as it seemed.
The business was reportedly earning $600,000 a year, but comparable deals put the business somewhere between $1.85 million and $2.42 million.
In other words, the $2 million the seller wanted at closing was already close to what the entire business might be worth. The buyer would still owe another $2 million on top of that.
Now, I generally like seller financing. It can be a really useful way to structure an acquisition and manage certain risks. That said, sometimes buyers can get so excited about how much the seller is willing to finance that they lose sight of what they're agreeing to pay.
A seller note changes when you pay for the business, but it doesn't change what you're paying for it.
Even if the price makes sense, you've still got to figure out whether the business can afford those payments.
That's why I always look at the valuation and the repayment terms separately.
One thing I've noticed is how a generous financing offer changes the way a buyer looks at a deal.
A buyer sees a business listed for $4 million and thinks, "That's pretty expensive." Then the seller offers to finance half the purchase price, and suddenly the conversation changes.
Instead of asking whether the business is actually worth $4 million, the buyer starts figuring out how to make the deal work.
Let's go back to the pool-installation business. At $4 million, the seller was asking about 6.7 times the company's reported $600,000 in annual earnings. Upon closer review, the comps suggested a multiple closer to 3.1 to 4.0 times earnings, putting the business's estimated value somewhere between $1.85 million and $2.42 million.
That's a pretty big gap. The asking price was roughly 65% to 116% higher than my estimated value range.
Of course, comps don't establish a company's definitive value. Growth prospects, management depth, customer concentration, asset requirements, and earnings quality can justify different multiples.
You want the valuation of the business to be defensible before determining how to finance it. This means examining normalized earnings, similar deals, and the risks or advantages that justify a discount or premium.
Ask yourself this: Would this business still be worth the asking price if the seller required full payment at closing?
If the answer is no, financing half the purchase doesn't solve the valuation problem. It simply postpones payment.
If a seller is willing to finance a substantial portion of the purchase price, doesn't that mean they're confident in the business and invested in your success?
That's how a lot of buyers see it. To some extent, they're right. After all, the seller has a financial interest in your ability to succeed and pay them back.
However, that doesn't mean the seller is taking on as much risk as you’d think.
Start with how much cash the seller receives at closing relative to what the business is actually worth.
In the pool-installation example, the seller wanted $2 million upfront. If the business is worth approximately that amount, the seller could walk away from closing having already collected close to its estimated value.
Of course, the seller would still want to collect the remaining $2 million. That's real money, and there's a real risk of losing it.
However, there's a big difference between risking repayment on a note after you've already collected roughly what the business is worth and financing half of a fairly valued acquisition.
Here's another thing to remember: the seller may want you to succeed, but that doesn't mean they're sharing your operating losses.
A conventional seller note isn't an earnout. If revenue falls, you lose a major customer, or profits come in below expectations, your scheduled payments will likely remain the same.
The seller's ability to collect may depend on how well the business performs, but your obligation to repay doesn't automatically shrink when earnings do.
Depending on how the note is structured, the consequences of default can extend beyond the business itself.
Even if the seller note is subordinated to bank financing, the seller may still have protections such as:
Subordination affects the seller's priority relative to other creditors, but it won’t eliminate the buyer's obligations or personal exposure.
That's why I pay attention to the actual terms of the note, not just the percentage the seller is willing to finance.
Seller financing can align incentives, but it doesn't necessarily mean the seller is sharing your downside.
Once you've looked at the purchase price and the seller's risk, the next question is whether the business can actually afford the financing.
This is where the repayment schedule matters. A favorable interest rate might sound attractive, but how quickly you have to repay the loan determines how much cash the business needs to generate each month.
Consider a hypothetical $2 million seller note at 6% annual interest. Let's compare a repayment schedule that pays off the note over five years with one that stretches payments over ten.
The five-year note requires nearly $16,500 more per month, or approximately $198,000 more annually, than the ten-year note.
Now, let's apply those hypothetical repayment schedules to the pool-installation business, which reported $600,000 in annual earnings.
Under the five-year schedule, the seller note alone would require approximately $464,000 in annual payments. That's more than three-quarters of the company's reported earnings, before accounting for any additional acquisition debt.
Here's the problem: $600,000 in reported earnings doesn't necessarily mean $600,000 is available to make loan payments.
Depending on how those earnings are calculated, the buyer may still need to account for replacement management compensation, taxes, capital expenditures, and working capital. If the acquisition also involves bank financing, those payments further reduce the cash available.
Under the ten-year schedule, annual payments fall to approximately $266,000, leaving considerably more room for other financial obligations. The tradeoff is that the buyer pays more interest over the life of the loan.
That's why I want to see the full repayment schedule for every acquisition loan and compare the combined payments against realistic cash available for debt service.
The question is whether the business can afford its debt payments while still generating enough cash to meet its other financial obligations.
Even if the business can comfortably cover its scheduled debt payments, there's another question I want buyers to consider: How much cash will they have left when something goes wrong?
Because something inevitably will.
I know of one acquisition where a truck engine failed during the first month of ownership. The new owner suddenly had a major repair to pay for, on top of the debt payments already coming due.
That's the kind of expense that can turn an otherwise manageable repayment schedule into a cash flow problem. Sometimes it's a major setback, like equipment breaking down. Other times, it's the everyday challenges of running a business, like customers paying late or expenses coming due before cash hits the bank account.
These working capital challenges can put pressure on a business that already has little room in its budget.
When most of the business's cash flow is tied up in debt payments, the buyer has much less wiggle room. If expenses are already tight, they may need to put more of their own money into the business, delay other expenses, or negotiate with creditors to get through a difficult period.
That's why I want buyers to stress-test their cash flow against potential setbacks before committing to a repayment schedule.
A repayment schedule needs to work under realistic operating conditions, including when things don't go according to plan.
Even a generous seller-financing offer can fall short in two fundamental ways: the purchase price may be unjustified, or the repayment terms may be unaffordable. Sometimes, both are true.
Ask yourself these two questions before you accept any seller financing terms, no matter how good it initially looks.
Establish sustainable earnings, examine comparable transactions, and assess the risks and advantages that affect the company's value.
In the pool-installation example, my estimated value range raised serious questions about the $4 million asking price before we even considered the financing.
If the seller asks for a premium, identify what justifies it. Maybe the company has valuable assets, unusually strong growth prospects, or other advantages that the initial comparison doesn't capture. This is entirely possible.
However, if the evidence doesn't support the price, renegotiate or reconsider the acquisition.
Once you've established a defensible price, examine the repayment obligations.
Obtain amortization schedules for every acquisition loan. Calculate total annual debt service, account for normal operating cash needs, and determine how much liquidity remains.
Then test less favorable outcomes. What if earnings fall 15%? What if the company needs a major equipment replacement? Can it meet its obligations without relying on immediate growth or unusually favorable working-capital conditions?
These scenarios can help you determine whether the proposed financing is affordable and what terms may need to change.
What should you do if the proposed seller note fails either of these tests?
Seller financing can be a great tool. It can mean less cash out of pocket, more flexibility, and terms you might not get from a bank.
But I wouldn't get too excited about the percentage the seller is willing to finance. I'd want to know whether the price makes sense, how much risk the seller is actually taking, and whether the business can comfortably make those payments while still having enough cash to operate.
At the end of the day, the goal is to buy a good business at a fair price, with financing that actually works.