# How does seller financing work in a business sale?
The seller lends the buyer part of the price and is repaid with interest under a promissory note. Terms, security, bank subordination, default and tax.
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Seller financing in a business sale means the seller accepts part of the price as a loan to the buyer instead of cash at closing: the buyer signs a promissory note, usually called a seller note, and repays it with interest over several years, with the business itself and often the buyer personally standing behind the debt. The seller becomes a lender, with a lender's questions to answer: how much, at what rate, secured by what, ranked behind whom, and what happens if the payments stop.
The mechanics described here are general and apply in most countries. The sections on security filings, the Small Business Administration and instalment-sale tax describe rules of the United States, and each one says so. All of it is general information, not legal or tax advice.
One worked example runs through the whole article. A business sells for $1,800,000. The buyer brings $360,000 of cash (20% of the price), a bank lends $900,000 (50%) and the seller carries a note of $540,000 (30%) at 8% a year. The seller therefore receives $1,260,000 on the closing day and the remaining $540,000 over time. Every figure is illustrative and computed from those assumptions.
$10,949monthly payment on the note when it is repaid in 60 level instalments
$373,673balloon due at month 60 if the same note is interest-only for a year, then repaid on a ten-year schedule
$492,224value today of the level-payment note to a seller who requires 12% a year for the risk
Worked example: a $540,000 seller note at 8% a year, monthly payments, five-year term. Illustrative figures.
## Why does a seller agree to finance part of the price?
A seller finances part of the price for three reasons: to close a gap between the price and what the buyer and the bank can fund, to show confidence in the business, and to obtain a price or a deal that an all-cash buyer would not offer.
The financing gap is the most common. When the bank's loan and the buyer's cash add up to less than the price, the difference is either taken off the price or carried by the seller. In the worked example, $360,000 of cash and $900,000 of bank debt reach $1,260,000, and the $540,000 note is what makes $1,800,000 possible.
A seller who leaves 30% of the price in the business is telling the buyer and the bank that the earnings shown in the sale documents are expected to continue. It also ties the seller's own money to a proper handover of customers and knowledge.
The price is the third reason. A buyer who can pay over time can pay more, and a seller who finances widens the pool of buyers able to bid at all. What the seller gives in exchange is certainty: money owed is not money received.
Seller financing is not an earn-out. A seller note is a fixed debt, owed whatever the business does after closing; an earn-out is a further price owed only if agreed targets are met. Deals that carry both draft them as separate instruments.
## What terms does a seller note contain?
A seller note states the amount lent, the interest rate, the term, the payment schedule, any period during which payments are reduced or suspended, the security, the rank of the debt against other lenders and the events that count as default. They are negotiated as a package.
| Term | What it fixes | In the worked example |
| --- | --- | --- |
| Amount | The share of the price left unpaid at closing | $540,000, 30% of $1,800,000 |
| Interest rate | The yearly charge on the unpaid balance, fixed or tied to a reference rate | 8% a year, fixed |
| Term | The date by which the whole note must be repaid | 5 years |
| Amortisation | The schedule on which principal is repaid, which may be longer than the term | 60 monthly payments, or a ten-year schedule with a balloon |
| Balloon | A single large payment of the balance left at the end of the term | None, or $373,673 at month 60 |
| Standby or interest-only period | A period with no payments, or with interest only | None, or 12 months of interest only |
| Prepayment | Whether the buyer may repay early, and at what cost | Allowed without penalty |
| Security and rank | What the seller can claim on default, and after whom | Second lien behind the bank |
The rate is negotiated against what the bank charges on the senior loan and what the seller could earn elsewhere at similar risk. Because a seller note normally ranks behind the bank, risk argues for a higher rate than the bank loan; in practice the rate is often traded against the price.
Term and amortisation are two different things. The term is when the note ends; the amortisation is the schedule used to calculate payments. A note with a five-year term and a ten-year amortisation has smaller payments and leaves a balance at the end, the balloon, which the buyer must pay from savings or by refinancing.
## How is a seller note repaid, month by month?
A seller note is repaid in instalments that each contain interest on the outstanding balance and a slice of principal, so the interest share falls and the principal share rises with every payment. On the $540,000 note at 8% over 60 months, the level payment is $10,949.25. The first payment contains $3,600.00 of interest ($540,000 at 8% divided by 12) and $7,349.25 of principal; the last contains almost no interest.
In the full schedule, grouped by year, the buyer pays the same $131,391 each year and a larger share of it reduces the debt.
| Year | Interest paid | Principal repaid | Balance at year end |
| --- | --- | --- | --- |
| 1 | $39,893 | $91,498 | $448,502 |
| 2 | $32,299 | $99,092 | $349,411 |
| 3 | $24,075 | $107,316 | $242,094 |
| 4 | $15,167 | $116,224 | $125,870 |
| 5 | $5,521 | $125,870 | $0 |
| **Total** | **$116,955** | **$540,000** | |
Over five years the seller collects $656,955: the $540,000 of price that was deferred and $116,955 of interest. Exposure falls slowly at the start: after a full year of payments the buyer still owes $448,502, or 83% of the note, and the early years are also when a new owner is most likely to stumble. A seller who wants exposure to fall faster asks for a shorter amortisation or more cash at closing, not for a higher rate.
## What do a balloon payment and an interest-only period change?
A balloon payment and an interest-only period both lower the buyer's payments in the early years and move the repayment of principal to the end of the note, which raises the seller's total interest and the seller's exposure at the same time.
Take the same $540,000 note at 8% and reshape it: interest only for the first 12 months, then monthly payments calculated on a ten-year amortisation, and the balance due in one payment at month 60.
| Feature | Level payments over 5 years | Interest-only year, then balloon |
| --- | --- | --- |
| Monthly payment, year 1 | $10,949 | $3,600 |
| Monthly payment, years 2 to 5 | $10,949 | $6,552 |
| Balloon at month 60 | None | $373,673 |
| Total interest received | $116,955 | $191,354 |
| Total received by the seller | $656,955 | $731,354 |
The second structure pays the seller $74,399 more interest only because $373,673 is still owed on the last day. A balloon is repaid from one of three sources: the buyer's accumulated cash, a refinancing by a bank, or a resale of the business. If none is available at month 60, the seller must choose between extending the note and declaring a default on a business that may be paying every instalment on time. A seller who accepts a balloon asks at signing how it will be paid.
## What secures a seller note?
A seller note is secured by a lien on the assets of the business, by a personal guarantee from the buyer, by a pledge of the shares of the company that was sold, or by a combination of the three. An unsecured note leaves the seller, on default, alongside the trade creditors.
| Security | What the seller can claim | What limits it |
| --- | --- | --- |
| Lien on business assets | Equipment, inventory, receivables and other assets named in a security agreement | Ranks behind any lender that filed first; assets lose value in a failing business |
| Personal guarantee | The buyer's personal assets, up to the amount guaranteed | Worth only what the guarantor owns; the bank usually holds one too |
| Pledge of shares | Ownership of the company, taken back on default | The company comes back with its debts, including the bank loan |
In the United States, a lien on business assets is created by a security agreement and made effective against other creditors by filing a financing statement, commonly called a UCC-1 after Article 9 of the Uniform Commercial Code, the model law adopted by the states. As the Code is published by Cornell Law School's Legal Information Institute, a financing statement is sufficient only if it gives the name of the debtor, the name of the secured party or its representative, and an indication of the collateral covered. It is filed in the state where the debtor is located, and a company registered under the law of a state is located in that state.
Competing perfected security interests rank by priority in time of filing or perfection, so a seller who files after the bank ranks after the bank. A filed financing statement is effective for five years from the date of filing and then lapses unless a continuation statement is filed within the six months before the five years expire, which a seller holding a longer note must put in a calendar. Each state enacts its own version of the Code, so the filing office, the form and the fee are checked state by state.
## What does subordination to a bank mean for the seller?
Subordination means the seller agrees that the bank is paid first: the bank's lien outranks the seller's, and the seller's right to collect, and sometimes even to receive scheduled payments, is restricted while the bank loan is outstanding. A bank that finances an acquisition normally makes this a condition of its loan.
The terms are set in an agreement between the two lenders, called an intercreditor agreement or a subordination agreement, and, where the seller receives no payments at all for a period, a standby agreement. Such an agreement typically settles five things:
- **Lien priority.** The bank's security interest ranks first on all collateral, whatever the dates of filing.
- **Payment blockage.** The seller may receive regular payments only while the bank loan is in good standing; if the buyer defaults towards the bank, payments to the seller stop.
- **Standstill.** After a default on the seller note, the seller must wait for a stated period before enforcing.
- **Turnover.** Money the seller receives in breach of the agreement is held for the bank and handed over.
- **Amendments.** Neither lender changes its loan in ways that hurt the other without consent.
Standby takes two forms. On partial standby the seller receives interest, or regular payments, as long as the senior loan performs. On full standby the seller receives nothing, neither principal nor interest, for the standby period, and interest either accrues or is waived depending on the note.
## How does the Small Business Administration treat seller notes in the United States?
In the United States, a loan guaranteed under the Small Business Administration's 7(a) programme can finance a change of ownership, and the programme's rules decide whether a seller note counts towards the buyer's required equity and when the seller may be paid. The SBA's own programme page, last updated on March 26, 2026, lists complete or partial changes of ownership among the approved uses and gives $5 million as the maximum 7(a) loan amount.
The detailed rules sit in the SBA's Standard Operating Procedure 50 10, the manual its lenders must follow. That manual sets the minimum equity a buyer must bring to a change of ownership, the conditions under which a seller note may count towards that equity, usually that the seller agrees to receive no payments for a period and ranks behind the lender, and how a seller note that does not meet those conditions is counted as debt when the lender tests whether the business can service its loans. The thresholds and the standby conditions have changed from one version of the manual to the next, so no figure is given here.
The lender's SBA department is the right place to confirm the current text before a note is priced around it.
## What happens if the buyer defaults?
When a buyer defaults on a seller note, the seller's remedies are, in rising order of severity, to negotiate new terms, to demand the whole balance, to enforce the security and the guarantee, and to take the business back.
A note normally defines default broadly: a missed payment that is not cured within a grace period, a breach of a covenant, a default on the bank loan (a cross-default), insolvency, or a sale of the business without consent. An acceleration clause then makes the entire balance due at once.
In the United States, Article 9 of the Uniform Commercial Code provides that after default a secured party may sell, lease, license or otherwise dispose of the collateral, and that every aspect of the disposition, including its method, manner, time, place and other terms, must be commercially reasonable. A seller in second rank does this subject to the bank's prior rights and after any standstill period.
Taking the business back sounds like the natural remedy and is the hardest one in practice. The seller gets back a business that has just failed to pay its debts, often with fewer customers, departed staff and unpaid suppliers. Where the security is a pledge of shares, the company returns with all its liabilities, the bank loan first among them, and the bank must be dealt with at once. Where the security is a lien on assets, the seller recovers equipment and inventory, not a running company with its contracts and licences.
For that reason most troubled seller notes are restructured before they are enforced: a period of interest only, a longer term, a partial payment in exchange for a release. Regular financial statements let the seller see the problem before the missed payment.
## How should a seller assess the buyer's credit?
A seller assesses a buyer the way a bank would: by testing whether the cash flow of the business covers all the debt with a margin, how much of the buyer's own money is at risk, whether the buyer can run this business, and what stands behind the personal guarantee.
The central test is the debt service coverage ratio: cash flow available to pay debt, divided by all the debt payments due in a year. Suppose the business in the worked example produces $420,000 a year after a market salary for the owner, and the $900,000 bank loan runs over ten years at 9.5%, costing $139,749 a year. With the level-payment seller note at $131,391 a year, total debt service is $271,140 and the ratio is 1.55, with $148,860 left after debt service. Cash flow would have to fall by 35.4% before the business could no longer pay both lenders in full.
With the interest-only year, debt service is $182,949 in year one (a ratio of 2.30) and $218,370 a year afterwards (1.92). The buyer gains room to absorb a difficult transition, and the seller's balance stays high for longer.
Beyond the ratio, a seller's file on the buyer usually holds a personal financial statement and a credit report obtained with consent, proof of the source of the cash paid at closing, evidence of experience in the industry, and the bank's commitment letter with its covenants.
## What is a seller note worth compared with cash?
A seller note is worth its face value only to a seller who would be satisfied with its interest rate as a return for its risk; to a seller who requires more, the note is worth less than the same amount in cash. Present value measures the gap: each future payment is discounted to today at the rate the seller requires.
A subordinated note from a newly indebted business is riskier than the bank's loan, so the required rate is normally above the note's 8% coupon. The chart shows what the two versions of the $540,000 note are worth today at four required rates.
Present value of a $540,000 seller note at 8%US dollars, by the yearly return the seller requires; monthly discounting over 60 months
Interest-only year, then balloonLevel payments over 5 years
Worked example. Payments are assumed to be made in full and on time; the required return is the seller's own judgement of the risk, not a market rate.
At a required return of 12%, the level-payment note is worth $492,224, which is $47,776 or 8.8% below its face value. The seller's $1,800,000 price is then worth $1,752,224 in cash terms: $1,260,000 received at closing plus the value of the note. The balloon version is worth $466,998, a discount of $73,002 or 13.5%, and the price falls to $1,726,998 in cash terms, even though that note pays more interest in total.
The calculation has three uses. It compares offers: an all-cash offer of $1,760,000 beats the $1,800,000 offer with the level-payment note for a seller who requires 12%. It prices the concession: for the note to be worth $540,000 at 12% on the same rate and schedule, its face amount would have to be $592,413, or $52,413 more. And it values an early payoff offered at a discount.
## How is a seller-financed sale taxed in the United States?
In the United States, a sale in which at least one payment is received after the tax year of the sale is an instalment sale, and the gain is generally reported as the payments come in instead of all at once. The Internal Revenue Service sets this out in its Topic 705 on instalment sales, a page last reviewed on September 24, 2026, and in its Publication 537.
According to those pages, the instalment method applies unless the seller elects out of it by the due date of the return, extensions included, by reporting the whole gain in the year of sale. Each payment has three parts: interest, a return of the seller's basis, and gain. The gain part is found with the gross profit percentage, which is gross profit divided by the contract price. Interest is generally taxed as ordinary income, and a contract without adequate stated interest may see part of its principal recharacterised as interest. The sale is reported on Form 6252 in the year it takes place and in each later year of the obligation.
A simplified illustration, ignoring the allocation among assets: if the seller's basis were $720,000, the gross profit on the $1,800,000 sale would be $1,080,000 and the gross profit percentage 60%. The $1,260,000 received at closing would carry $756,000 of gain in the year of sale, and the $540,000 of note principal would carry the remaining $324,000 as it is repaid, for instance $54,899 on the $91,498 of principal repaid in year one.
A business sale is rarely that simple, and Publication 537 says why. The selling price and the payments received in the year of sale must be allocated among the classes of assets sold. The sale of inventory cannot be reported on the instalment method, a sale at a loss cannot either, and depreciation recapture income must be reported in the year of sale whether or not a payment was received that year. A seller can therefore owe tax in the first year on money that will arrive later.
Other countries tax deferred consideration differently, and the rule is checked for the seller's own country.
## Which terms should be settled before signing?
A seller note is ready to sign when every item below has an answer in writing, in the note, the security documents or the agreement between the lenders.
- **Rate.** Fixed or floating, the day-count basis, and a default rate that applies after a missed payment.
- **Schedule.** Term, amortisation, first payment date, any interest-only or standby period, and whether unpaid interest accrues during it.
- **Balloon.** Its amount, its date, and the buyer's stated source of repayment.
- **Prepayment.** Whether early repayment is free, and whether a resale of the business makes the note due at once.
- **Security.** The security agreement, the collateral description, the financing statement filed in the right state and a calendar entry for its continuation.
- **Guarantees.** Who signs, for how much, with what financial statement in support.
- **Rank.** The intercreditor or standby agreement: payment blockage, standstill length, turnover, and limits on amendments.
- **Covenants.** Regular financial statements, limits on new debt, on distributions to the owners and on asset sales, and insurance on the assets.
- **Default.** The events, the grace periods, the cross-default with the bank loan, acceleration and the costs of enforcement.
- **Set-off.** Whether the buyer may deduct warranty claims under the sale agreement from payments on the note, and by what procedure.
The set-off clause is the one sellers overlook. A buyer who believes a warranty was breached will be tempted to stop paying the note; a seller prefers a clause that requires the claim to be established first.