Every so often a business owner will ask me whether they should rent the business to a potential buyer rather than sell the business to them. These business owners also own the real estate so it makes sense to them to get rent for a long time rather than sell the business for a one-time payment. Renting a business to a potential buyer is not the same as renting real estate, and not a good idea.
The primary reason not to rent the business to a buyer is the cost if the buyer fails. If the buyer is paying rent on the real estate and the business fails, the real estate can be rented to someone else, probably at a similar rent. The real estate is the same no matter how the buyer does with the business. At worst, a seller may lose a few month’s rent. The same is not true of the business. If the buyer fails, the business is probably in much worse shape than when it was rented to the buyer. If the buyer has failed, the business is probably not generating an income to him and has little value to another buyer. When renting a business, the owner is taking on the risk of the buyer’s business. If this reason isn’t enough, by itself, to not rent a business, here are a few others.
When a person buys a business, they usually get financing. In order to get financing from an SBA lender, which is the most common way our buyers get their financing, they need to have certain qualifications. The lender will look that they are qualified financially with a good credit score. The lender will also look at their business background to be sure they are likely to succeed in the business. This qualification process is a good screening for a seller that the buyer is likely to succeed.
There is also another requirement that lenders have. The buyer needs a down payment. It is usually 10% to 25% of the loan amount. This down payment serves another purpose. It means that the buyer has some “skin in the game”. Most buyers are going to work harder to make the business succeed when they have a lot more to lose than the security deposit on an agreement to rent the business.
In most business sales, the seller wants to finance as little as possible. They want the money at the closing. Usually, that’s what they get – 90% to 100% of the purchase price at the closing. If the business is rented out, the seller gets little when the buyer takes over the business. What is really happening here is that the seller is investing in the buyer’s business. The same seller, who doesn’t want to do seller financing, is doing it, consciously or not. If the seller gets the purchase price at the closing, he can decide where to invest the money – usually in safer investments than a small business with a new owner.
Another reason to sell rather than rent is that the taxes are lower. The taxes on rent are at the normal rate. The taxes on the sale are usually largely capital gains – taxed at a much lower rate. And, of course, it is a lump sum now that the seller can use for any purpose.
Although it appears attractive to rent a business, rather than selling it, looking into it further should convince you that it is not a good idea.