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How to determine creditworthiness of potential partners

How to determine creditworthiness of potential partners
Legal Matters: A sale of a family farm may involve seller financing.

A sale of a family-owned farm or other business may involve seller financing, where the owner sells assets to a buyer on an installment sale using a promissory note or a land contract. You may be willing to provide the buyer with financing to allow a family member, key employee, neighbor or other individual the opportunity to gain ownership on more beneficial terms than a bank would offer, or the individual may be entirely unable to obtain financing from a bank.

Regardless of who the purchaser is, you should be cognizant of the purchaser’s ability to satisfy the obligations he, she or it is entering into. 

Advantages to buyer, seller

SELLER FINANCING: Without a bank involved in the sale of a farm, the seller should take steps to ensure that the buyer is creditworthy and will honor the transaction obligations.

There are various reasons why a farm sale might involve seller financing; some may benefit the seller, and some may benefit the buyer. A couple of benefits for the seller are that the seller will receive a higher amount of total payments with the interest payments, and the seller may have the ability to spread income taxes over the payment period. A seller-financed transaction may be beneficial for the buyer because there may be lower, or no, loan transaction and closing costs; the seller may charge a lower interest rate; and the seller may require a lower down payment. 

However, without a bank involved, the seller should take steps to ensure the buyer is creditworthy and will honor the transaction obligations. The analysis that banks use to determine the creditworthiness of a borrower is commonly referred to as the five C’s of credit: character, capital, capacity, conditions and collateral.

• Character generally refers to the buyer’s honesty and integrity, and quantitatively is demonstrated with a strong credit rating.

• Capital is similar to the net worth of the buyer as shown on a balance sheet and dictates the buyer’s ability to sustain periods of low income.

• Capacity is a cash-flow statement factor that determines the buyer’s ability to pay all business expenses along with the obligation to the seller. 

• Conditions is a broad analysis to determine the general market factors in the industry.

• Collateral is the security the seller will have in the assets that are sold in the event of a default in payment. 

Think like a banker

While you do not have the resources a bank has, you should still try to think like a banker. The prospective buyer’s credit report and score is a good place to start because his or her report will summarize payment history, missed payments, debt load, etc. In most cases, you need permission before obtaining an individual’s credit report, so you should get written permission from the individual before obtaining their credit report from online credit reporting agencies. Both parties may be more comfortable if the buyer obtains his or her own credit report and provides it to you.

There are various other steps you can take to determine the prospective buyer’s creditworthiness. Review CCAP, the Wisconsin Circuit Court Access page, to determine if the buyer has judgments against him or her. Request that the buyer provide you with a balance sheet that he or she compiled with their banker or accountant. Can the buyer provide a cash flow or income statement? These tools will help determine the buyer’s capacity to pay the transaction obligations. Ask for a credit reference, which may be a bank the buyer works with, that you can speak with about the buyer’s payment habits. Your banker or accountant may be willing and able to assist you in reviewing this information to determine if the prospective buyer is creditworthy.   

The focus of this article is not on the terms of a seller-financed transaction, and you should meet with your trusted advisers, including your accountant, banker and attorney, to ensure the structure maximizes financial benefits and minimizes risk. However, you should be thinking of and discussing the following provisions, among others:

1. your security interest in the sold assets

2. the requirement for the buyer to insure the property

3. the requirement that the unpaid amount be fully due if the buyer sells the assets to a third party

4. the interest rate charged to the buyer

This is not an exhaustive list of the important provisions of a seller-financed sale of your farm, and there will be negotiations between you and the buyer to reach an agreement and structure that works for both parties.

There are positives and negatives for you as a seller to enter into a seller-financed transaction to sell some or all of your farm assets. You may not be able to enter into a transaction like this if you have significant debt on the assets being sold, in which case you may need a full cash payment to pay off your debt.  However, if you are contemplating selling your farm assets and providing financing to the buyer, you should perform your due diligence on the buyer to ensure he or she will pay on the obligations, and you will want to work with your trusted advisers to ensure the transaction is structured in a manner that minimizes the risks to you.    

Knickelbein is an attorney in the ag law firm of Twohig, Rietbrock, Schneider and Halbach S.C. Call Knickelbein at 920-849-4999.

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