What are Seller’s Notes and How do They Work?

When you sell your business, it’s usually the single largest monetization of wealth of your lifetime. There are millions of dollars, and years of your life, on the line. As such, it can be a stressful time for most owners.

It mostly gets stressful because of all the various legal documents involved throughout the sales process, as well as the large amount of documentation organized in an online data room and presented to potential buyers. It’s an investment in time and energy, all while you’re continuing to run your company and achieve the goals and objectives you’ve planned for.  It’s a lot for anyone to handle.

We won’t cover all of that here, and you can read our other articles that cover all aspects of an business sale. Today, we want to go over one of the least understood facets of a major business sale: the seller note.

The seller note is a key piece of any large-scale business acquisition, but it can be overwhelming to understand.

We’re going to go over what it is, how it works, and why you want to provide it to your buyers.

Let’s get started.

What is a Seller’s Note in a Business Acquisition?

The most basic definition of a seller’s note is that it’s simply a written debt agreement between the owner/seller and the buyer. Instead of paying the entire cost of the business upfront, the buyer goes into debt with the seller, making payments on the seller note until they have fulfilled the transaction agreement in full.

This is a great option for both sellers and buyers, and it opens up a number of opportunities during the transaction that we’ll cover in the following sections.

How Does a Seller’s Note Work?

Unless you’re Jeff Bezos, or someone else who has amassed an obscene amount of personal wealth, spending $10, $20, or even $80 million dollars in one lump sum is a tremendous transaction, even if you’re a successful business owner with plenty of company assets and a fair share of personal wealth. As such, the majority of people looking to purchase your business are going to be relying on financial loans or payment agreements. They’re not just going to walk into your office with a briefcase of money. This sounds obvious, but bear with us.  There is a lot of complexity in deal terms, so we want to try and keep this simple and stay focused on how deals are structured leveraging seller notes.

Seller notes are a form of financing provided on behalf of the business owner selling their business to make the transaction more feasible for the vast majority of buyers.  This structure also ensures the business owner who sells the company has “skin in the game” post-sale, versus walking off into the sunset to never be heard from again.  The seller note helps keep the lines of communication open between the buyer and seller, should the buyer need help owning and operating the business.

How does it work, though?

Affordable Payment Option:

First and foremost, if the company making the purchase simply cannot pay upfront, a seller’s note is used to make the purchase far more affordable by financing the sale over time. This is like purchasing a new car. Rarely, if ever, do people walk into the dealership, drop a bunch of cash, and drive away with a paid-off vehicle. Instead, they pay a small percentage of the overall cost, and then they make monthly payments.

A seller’s note allows that to be done during a business acquisition.

Let’s say the company making the purchase has good reason to avoid paying for the total price of the business upfront. The buyer can ask for a seller’s note, make a sizeable “down payment” in good faith, and then pay the rest off in set intervals, typically monthly.  If the buyer has also set up debt financing through a bank, the seller note is subordinated to the bank note, increasing the term of the note to usually a year after the term of the debt financing. 

When this is done, there are a multitude of clauses and options for adjustment set into the seller note agreement to ensure the continued transaction is mutually beneficial. These can be things such as profit-based payments, performance benchmarks that prove the company’s viability, seller buy-back provisions should the company default on its payments or not achieve the covenants outlined in the note, etc.

Bridging the Gap:

This is the most common way a seller’s note is used. As we highlighted multiple times before, the average acquirer doesn’t have tens of millions of dollars laying around to pay everything upfront. In many cases, the buyer might be properly funded to pay $10 million on a 12-million-dollar business. And as we described previously, that buyer could finance the $10mm with $1mm of their own money, with the remaining $9mm financed with bank debt and investment funding.  That leaves a $2mm seller note.

Instead of tossing out the transaction entirely and starting the entire process over again with a new buyer, the seller can issue a seller’s note to bridge the gap.

In this case, the buyer pays the seller $10 million up front like they’re capable of. However, the seller doesn’t have to sacrifice the remaining $2 million. They can let the buyer pay it off in payments through the seller note.

Those payments will have to be agreed upon between the buyer and the seller. They can resemble smaller monthly payments, quarterly payments that are more substantial, or even annual payments based on the profitability of the business. The exact terms used are negotiable, but it’s best to stick to tried and true payment methods rather than reinventing the wheel. By using standard seller note agreements, you can prevent confusion between both parties and ensure everyone is protected against potential issues with the agreement.

This nets the seller the majority of the transaction money up front, and it “guarantees” that the seller receives the full asking price of the business eventually, but it also offers flexibility to the buyer, as they’re able to pay what they can, and then pay off the rest over time.

Buy-Sell Agreements

This is a more unique use for a seller note, and it has no involvement with outside parties. Instead, it’s used between two business partners in the same company.

Let’s say you entered the business with a close friend, and you both built up the business to be worth $15 million over the course of twenty years. You both own ten million shares with the two friends each owning 50% of the business. Now, you two are experiencing tension, or you simply want to depart the company to focus on enjoying your life with the wealth you’ve accrued.

Your half of the business doesn’t just get handed over to your partner. They have to buy that half of the business from you.

Obviously, purchasing $10 million worth of shares from you might not be possible for your partner to do out-of-pocket. They might only have the personal wealth available to purchase half of that.

Luckily, rather than demanding the partner hand over money they don’t have, or settling for less than your half of what the business is worth, you can issue a seller note to your partner.

As with the previous example, this will allow your partner to payout your total asking price over time. They’ll still pay as much as they can towards it, but what is left over will be split into regular payments over time.

This obviously makes the transaction easier for your partner, especially since it can be rather abruptly thrust on them at times, and it can make the transaction go over more smoothly – a key point when two friends, family members, or close acquaintances are ending a business relationship.

However, there are other times this type of seller note might be issued. For example, if you’re the spouse or child of a business owner who just died, and you have legal rights to that owner’s share of a business partnership, you might issue a seller note to facilitate the transaction and get what you’re owed.

Selling to Management

Let’s say that you’ve been operating a business for the past thirty years, and you’ve become close friends with not just your key employees, but also with those at the bottom of the company ladder. Now that you’re old enough to retire, you don’t want to derail their entire livelihoods and change the way their day-to-day lives operate out of nowhere by selling the company outright to a third party. So, who better to sell your business to than the people who have been the key parts of its operation for decades?

Selling your business to management is a great option, especially if your business is a bit smaller in scope because it ensures that the business and all of its employees are preserved, and it’s the ultimate way to reward good service from your employees. Your top management members become owners, and employees down the ladder tend to move up to fill in the vacated slots.

However, this management buyout structure is also complicated. While you’ve been building your company’s value into the millions, your employees, even your top managers, probably haven’t earned enough to buy the company outright, even if you’re paying them very handsome wages.  There are also taxes involved in transferring ownership to your management team, which if not structured properly, could give a significant tax bill to management that is several multiples above their current earnings.

So, their ability to pay for the company outright is far less than that of an investor or another business owner.

Luckily, you can make it easier on them. When selling the business to your management team, you can issue a seller note that allows each member to pay the total cost over time.  You can even transfer ownership over time, spreading the taxable burden over several years versus a lump sum.

This allows you to pass your business down to those who have made it possible, but it doesn’t financially cripple them in the process, or lock them out from potentially making the purchase due to financial reasons.

How the Seller Note Works: Issuing a Seller Note

In the previous section, issuing a seller’s note might have sounded extremely simple. However, it’s more complicated than simply typing out and signing a debt agreement or promissory note. There are different conditions you need to understand.

It Does Not Take Precedence:

First and foremost, a seller note does not take precedence over other debt instruments in place at the time of the business sale.

Typically, a seller note is offered after the purchaser, whether that is an investor, management team, partner, or anyone else, has already sought out funding from a financial institution to cover the remainder of the purchase price. As such, that means the buyer also has a debt to a financial institution on top of the debt they owe to you via the seller’s note.

In this situation, the debt to the financial institution takes precedence over your seller’s note. Or, in banker terms, the seller note us subordinate to the financial debt instrument.

This is called Senior Debt, and while it doesn’t have an impact on your agreement when the buyer is making payments on time and fulfilling their obligations, it does make an impact if you’re forced to take the matter to court or seek restitution for a refusal to pay or other issues. The debt to the financial institution is taken into account first, and it will be the priority if collectors are forced to get involved.

Higher Interest Rates:

As a seller, this is a positive aspect of a seller note for you, but it can make the buyer a little more wary about entering into such an agreement.

Since a seller note carries more risk, as outlined in the previous section due to Senior Debt taking priority, interest rates are set higher on seller notes to offset that risk.

When a buyer goes to a financial institution for funding, they’ll typically pay interest that is one or two points above par value, say 4 to 5% in this example, not taking into account inflation and rising interest rates due to rate increases by the Federal Reserve. A seller note will typically come with 6% to 10% interest rates, higher than the interest on the senior debt instrument. Considering these are typically multi-million-dollar transactions, the interest rate of the seller note will result in additional interest costs that the business’s cash flow and net profits must cover.

This is why the first option at a buyer’s disposal is to simply approach the bank with a request for a larger loan facility. Unfortunately, banks often will not exceed the threshold of what they’re comfortable lending, and this doesn’t always work, making the higher interest rates necessary in order for the owner to agree to a seller note.

Different Interest Types:

It’s important to know the two types of interest that a seller’s note can carry with it. Offering the wrong type can scare off the buyer.

First, there is “Bullet” interest. This is a flat interest rate that is added up at the end and paid upon maturity of the loan. This gets rid of continuously rising interest amounts, but it hits the buyer with a sudden payment as they pay the loan off, and it equates to a higher interest rate overall.  Think of this like a balloon payment if you lease a car, which is usually added onto the end of the lease term.

Then, there is PIK, or “Paid in Kind” interest. This is the type of interest most people are familiar with. The rate is typically lower, falling into the 5% to 7% range usually, but the total costs added to payments annually continuously increase.

Choose the interest type that best suits your buyer to avoid scaring them away from the seller note, and potentially, the purchase.

Get Help with Your Seller Note

Every aspect of selling a business is complex, and if you attempt to do it on your own, you can miss out on a large sum of money you’re rightfully owed.

Instead of writing seller notes on your own, evaluating your business without help, or doing anything else by yourself, consider hiring a professional team of M&A advisors, like IAG, to help guide you through the entire selling process.


Guest blog courtesy of IAG, a preferred brokerage partner of Acquira.

Accelerator

Leave a Reply

Your email address will not be published. Required fields are marked *