Using Real Estate Equity to Finance the Sale of Your California Business

Can Your Real Estate Help You Sell Your Business?

Sometimes the obstacle to selling a good business is not the business. It is the financing. A qualified buyer may want the company. The business may generate sufficient cash flow to support an acquisition. The seller and buyer may even agree on price. But the buyer cannot assemble enough capital to consummate the transaction. If the seller also owns valuable commercial real estate, there may be another source of transaction capital hiding in plain sight: the seller's real estate equity.

In the right transaction, an owner may be able to:

1. Sell the operating business;

2. Keep the real estate;

3. Refinance part of the equity in the property;

4. Use that liquidity to help structure seller financing for the buyer;

5. Collect rent from the buyer after closing; and

6. Receive principal and interest on the seller-financed portion of the business purchase price.

   
   

The seller does not necessarily have to choose between selling the building and leaving all of its equity untouched. There may be a middle ground.

The Seller Must View the Business and Real Property as Two Separate Assets

Assume a California owner has:

Business value: $2,000,000

Commercial real-estate value: $3,000,000

Existing real-estate loan: $500,000

There is approximately $2.5 million of gross equity in the property before refinancing costs and other considerations.

Now assume a qualified buyer wants to purchase the business for $2 million.

The buyer can assemble $1.5 million through buyer equity and acquisition financing but remains $500,000 short.

Traditionally, the seller has several choices:

• Reduce the price.

• Wait for another buyer.

• Carry a $500,000 seller note using the seller's own available liquidity.

• Or simply refuse the transaction.

But ownership of the real estate may create another alternative.

Refinancing Real Estate Equity to Facilitate the Business Sale

If the seller refinances the commercial property and extracts $500,000 of equity, the $500,000 that previously existed as illiquid equity inside the building is now available as transaction capital while the real property remains owned by the seller.  Now, the business acquisition can potentially be structured so that the seller finances an agreed portion of the purchase price through an appropriately documented seller obligation.

After closing, the seller may own:

• The commercial property

• A promissory note from the business buyer

while also receiving:

• Rent from the business

• Principal and interest on the seller note.

The seller has not created free money. The seller has simply reallocated capital. Part of the equity formerly locked inside the real estate has been converted into liquidity and then into a receivable from the business buyer.

Whether this is a smart transaction is case/situational dependent and highly variable based on underlying factors such the risk, the financing terms the economics and many other variables.

Why Would a Seller Consider This Mechanism to Finance the Transaction?

The answer is simple: It may make a business sale possible without requiring the seller to sell the real estate. That can be very attractive when a seller wants to retire from operating the company but wants to retain the real estate as a long-term investment.

Scenarios for a Seller who Owns Both the Business and Real Estate:

Without the strategy:

Seller owns business + building.

After a conventional complete sale:

Seller owns cash.

After a business-only sale with retained property:

Seller owns cash + building + rental income.

And after a properly structured retained-property/seller-financing transaction:

Seller may own cash + building + rental income + seller note.

For some sellers, that combination may better match their retirement or investment objectives.

Seller Financing Means the Seller Becomes a Lender

Be cautious. Seller financing should never be viewed merely as a creative way to “get the deal done.”  The moment a seller agrees to receive part of the purchase price later, the seller takes credit risk.  If the seller has refinanced previously unencumbered or lightly encumbered real estate to facilitate that financing, the stakes can be even higher.  The seller now owes money to a real-estate lender regardless of whether the business buyer pays the seller note.

Sellers must vet the prospective Borrower (Buyer) to ensure they are creditworthy and capable of successfully operating the purchased business and repaying the Seller note. This means vetting the buyer as a lender would.  This can be a very grueling process that should be undertaken in a pragmatic step by step process. That process will be addressed in another presentation by this author.  Seller’s should not be lulled into lending to “bridge the gap” on a business purchase unless the Buyer is a good credit risk.  A seller who would never make a $500,000 loan to a stranger should not make one simply because the borrower is buying the seller's company.

The Business Must Support the Entire Capital Structure

It is easy to make a transaction work on paper by adding more financing.  But debt does not make a business more profitable.

Suppose the business historically produces enough normalized cash flow to support:

• the buyer's compensation;

• working capital;

• senior acquisition debt;

• rent; and

• seller-note payments.

The structure may make sense.  But if the only way to achieve the seller's desired purchase price is to load the company with obligations it cannot realistically service, refinancing the property does not solve the underlying problem. It merely moves risk around and places more of it on the Seller who is now also a lender.

The question is: Can the acquired business reasonably support all obligations after closing?

The Seller May Wear Three Hats After Closing

Where the seller retains the property and finances part of the acquisition, the seller may have three distinct relationships with the buyer.

1. Former Owner

The seller has transferred the operating company and no longer runs the business.

2. Landlord

The business occupies the seller's real estate and owes rent under a commercial lease.

3. Lender

The buyer owes principal and interest under the seller-financing documents.

Those relationships need to be coordinated. For example:

What if the buyer pays rent but defaults on the seller note?

What if the buyer makes the seller-note payments but stops paying rent?

What if the senior acquisition lender takes control of the business?

Can the lease be assigned?

Can the buyer sell the company?

What happens to the seller note if the business is resold?

Are the seller's collateral rights subordinate to the bank?

Can a successor operator occupy the property?

These issues are interrelated and must be negotiated before closing.

The Lease Is Part of the Credit Analysis

If the seller is relying on the business to pay both rent and a seller note, lease economics matter.  An excessively high rent may increase the value of the seller's real-estate income stream while simultaneously weakening the tenant's ability to make payments on the business acquisition debt. This could be self-defeating.  The parties should examine a sustainable market rent and realistic normalized cash flow.

The transaction will only work when those competing economics are viewed as one capital structure. The seller wants the highest business price, The landlord wants the highest rent, The senior lender (if any) wants the lowest leverage, The seller-lender wants rapid repayment, The buyer needs enough cash flow to operate. A transaction is likely to fail when everyone negotiates each component separately.

Don’t Forget About a Future Sale of the Real Estate

A seller may plan to retain the building today but decide to sell it several years later. That future decision may have consequences for the business tenant.  California generally reassesses real property after a qualifying change in ownership.  The Board of Equalization has specific rules for leased property and identifies a transfer of the lessor's interest subject to a lease with less than 35 years remaining, including written renewal options, as a change in ownership.

Why does that matter? Because many commercial leases require the tenant to pay property taxes directly or through CAM or other operating-expense provisions.  If the property has a low historical assessed value and is later sold at a substantially higher value, the resulting property-tax increase can materially increase the tenant's occupancy expense. That can reduce the cash flow available to service acquisition debt—including the seller's note.

The lease and seller financing should not be negotiated in isolation.

Seller Financing and Installment-Sale Tax Treatment

Seller financing can also affect when taxable gain is recognized.  An installment sale generally involves at least one payment after the tax year in which the sale occurs. But a business sale is more complicated than simply saying, “I carried a note, so all of my tax is deferred.”  The IRS expressly states that an installment sale of an entire business for one overall price is not treated as the sale of a single asset. The purchase price must generally be allocated among the various assets, and different rules can apply to inventory, depreciable assets, goodwill and other components. The IRS also requires the residual method for allocating consideration in qualifying asset acquisitions of a trade or business, and buyer and seller generally report the allocation on Form 8594.

While every business sale should have a tax expert on the team, Selling a business with Seller financing is even more complex.  The parties take a very large risk if they do not have the transaction reviewed with a tax adviser before the economics are finalized.  The tax treatment should follow the transaction - not be guessed after the purchase agreement is signed.

What About SBA Acquisition Financing?

Many small-business acquisitions involve SBA-supported or conventional lending, but at times that is not enough to consummate the sale. That is where Seller financing comes in.  Seller financing may interact with senior acquisition financing, including requirements relating to buyer equity, subordination, standby arrangements, lien priority and debt-service analysis.

These rules can change.  Accordingly, the parties should involve the acquisition lender before committing to the seller-note structure rather than assuming the bank will accept it after the letter of intent is signed. The key point is to consider the seller financing as part of the overall transaction, rather than designing it in isolation. Coordinate the business purchase agreement, acquisition loan, seller note, security documents and lease as one large transaction as each impacts the others.

When Does Using Real Estate Equity Make Sense?

This strategy may deserve consideration when:

• the seller has substantial real-estate equity;

• the seller wants to retain the property;

• the buyer is otherwise qualified;

• a manageable financing gap is preventing the acquisition;

• the business has sufficient post-closing cash flow;

• market rent supports the transaction;

• the seller understands and accepts buyer credit risk; and

• the overall transaction still works if one component underperforms.

It may be inappropriate when:

• the seller needs complete liquidity;

• the seller cannot tolerate buyer default risk;

• refinancing would overburden the property;

• the business cannot support rent plus acquisition debt;

• the buyer is undercapitalized;

• the seller note would be poorly secured; or

• the transaction works only under optimistic projections.

Creative financing cannot substitute for sound underwriting.

Frequently Asked Questions

Can a seller refinance commercial real estate to help finance a business buyer?

Potentially, yes. A seller with sufficient property equity may explore refinancing and using available liquidity as part of a broader transaction strategy. The refinancing, seller-financing documents and senior acquisition loan must all be evaluated together.

Can a seller keep the real property after selling the business?

Yes. A buyer can acquire the operating business while leasing the premises from the former owner.

Can a seller receive rent and seller-note payments from the same buyer?

Potentially. The buyer may owe rent under the lease and principal and interest under separate seller-financing documents. The business must have adequate cash flow to support both obligations.

Is seller financing risky?

Yes. Seller financing creates borrower credit and collection risk. If the seller refinances real estate to facilitate the transaction, the seller may also have a new mortgage obligation that exists whether or not the buyer pays.

Is a seller-financed business sale automatically an installment sale for all tax purposes?

No. The tax treatment is asset-specific. The IRS states that a sale of an entire business for one overall price is not treated as the sale of a single asset for installment-sale purposes.

Can a later sale of the building affect the business buyer?

Yes. A qualifying California change in ownership can result in reassessment, and if the lease passes property taxes through to the tenant, the business's occupancy cost can increase dramatically.

Should a strategy be planned before listing the business?

Ideally, yes. Business value, property value, rent, refinancing capacity, buyer financing, tax consequences and seller-credit risk can all affect the appropriate structure.

The Real Estate May Be More Than the Place Where the Business Operates

For many owners, commercial real estate represents decades of accumulated equity.  When it comes time to sell the operating business, that equity should not automatically be ignored and the property does not necessarily have to be sold.  In the right circumstances, the owner may be able to sell the business, retain the building, generate rental income and strategically use a portion of real-estate equity to help bridge a buyer's financing gap.

The concept is powerful precisely because it treats the business and real estate as separate assets while planning them as part of a single economic transaction.

At LegalWise Business Brokers, we believe owners who control both a business and its real estate should evaluate these alternatives before determining how the business will be marketed.

Sometimes the right structure is a complete sale.

Sometimes, the transaction involves the sale of the business while the seller remains the landlord.

And sometimes the real estate itself can provide the financial flexibility that allows the business transaction to close.

If you are considering selling a California business and own the underlying commercial real estate, LegalWise Business Brokers can help evaluate the business, real-estate and transaction structure before the assets are taken to market.

Disclaimer: This article is provided for general educational and informational purposes only. It is not legal, tax, accounting, valuation, investment, or lending advice and does not create a broker-client or other professional relationship. Every transaction is different.  Business owners, Sellers, and Buyers should consult appropriately qualified professionals regarding their specific circumstances. 

AI Disclosure:  This post was written with the assistance of an AI language model. The human author provided the topic and key points, verified the information, and performed all final editing. The AI (ChatGPT) helped expand on the details and refine the writing. The final content was reviewed and edited by a human to ensure accuracy and quality.