When selling your business, one of the main things you want to know is how much cash you’re going to receive at closing. It’s important to have trusted advisors perform business valuations on your company so that you have a better idea of the amount of cash you can expect to earn from the sale.
But even with a proper valuation there are other factors to consider when planning how much you’ll receive from a business sale. One such example is a seller note. A seller note is a promissory note often built into the deal structure to help protect the buyer.
In this article, you’ll learn everything you need to know about seller notes and how they can impact the sale of your business. Specifically, you’ll learn what a seller note is, when and why it’s typically used, and the pros and cons of using one during the sales process.
What Is a Seller’s Note?
It’s rare for sellers to receive all-cash payouts during the business acquisition process. Nearly every buyer is going to ask for some portion of the purchase price to be held back. One way to do this is with a seller note.
If a seller note is part of the deal structure, the seller agrees to receive a portion of the proceeds from the sale as a series of debt payments. Though the terms of the note can vary from sale to sale, sellers can expect to hold back at least 10–20% of the purchase price in the form of a note.
While it would be ideal to receive all-cash at closing, that can seem unreasonable to both buyers and lenders. In fact, seller notes are customary in lower middle market transactions (companies with revenues between $5 million and $25 million), and something that sellers should anticipate if they’re serious about selling their business.
When and Why Would You Use a Seller Note?
There are two primary instances for using a seller note. The first is when buyers suggest them as a way to protect their new assets. The note acts as a form of contingency, keeping sellers engaged during the transition of the business. If a seller note is in place, the current business owners have a vested interest in a successful transition. It forces them to be involved for a period of time after the sale is complete.
The second instance is using a seller note as a form of debt financing. The note could bridge the gap between the seller’s intended sale price and what the buyer is willing or able to pay. A seller note comes with pre-defined interest rates and repayment schedules, allowing the buyer to predict future cash flow as a result of the sale.
Seller notes are extended by the current seller to the proposed buyer. For instance, let’s say you’re completing a sale of your business for $10 million, but the buyer only has $9 million available. You could extend a seller note for $1 million to help cover the difference.
It’s also worth noting that there are other types of contingent payments available as part of seller financings, like earnouts and escrow holdbacks.
If you’re using a Small Business Administration guaranteed loan (SBA loan), there may be some stipulations in place when it comes to seller notes. In most cases, the SBA will actually insist that the seller holds back 10–15% of the purchase price in the form of a note. The SBA requires sellers to hold back at least 5% minimum. Seller’s notes can also be subordinate to senior debt and bank loans if an SBA guarantee is involved.
What Are the Advantages of Using a Seller Note?
There are three leading reasons (and advantages) for using a seller note in mergers and acquisitions (M&A):
- As a show of good faith by the seller, indicating that they believe the business will continue to run successfully after they are gone.
- It keeps the seller financially tied to the business for a period after the sale, ensuring that they’ll be more willing to help the new owner succeed.
- To cover a valuation gap or make up for the buyer’s inability to come up with the liquidity required for the sale.
If used correctly, seller notes can help ensure that you receive monthly payments for a few years after the sale of your business. Receiving the full purchase price over a number of years (rather than all in one year) can also be advantageous from a tax standpoint as you’ll lower your annual taxable income. If you receive the entirety of the funds upfront, it could put you in a higher tax bracket and therefore subject more of your earnings to taxes.
Your trusted advisory and management team can perform the due diligence required to ensure your best interests are protected during a sale.
What Are the Disadvantages of Using a Seller Note?
Seller notes can be advantageous to both buyers and sellers. They can help buyers secure the funds needed to cover the working capital of their target company. It can also free up as much cash as possible for the buyer, which can help as the business transitions to new ownership. Seller notes can also prevent buyers from having to secure financing from private equity groups or traditional lenders. Instead, they can work with the seller directly.
That said, there are a few caveats to consider. For one, seller notes are usually unsecured or subordinated to senior debt, which makes the debt riskier and requires a higher interest rate. Some sophisticated buyers will promote seller notes as having a better interest rate than the ongoing market rate for similar maturities. As a seller, this is yet another example of why having a trusted team of advisors is crucial to protect your interests.
A seller holding the note must ensure the interest rate is sufficient to make up for the company’s risk profile and its potential inability to generate free cash flow to service and pay off the debt. A seller is better off requiring a set principal repayment schedule which, if not met, would allow the debt to convert to equity through the exercise of an equity kicker. Sellers need to work with their team of advisors to protect themselves in case a buyer defaults on the note.
Lastly, the term of a seller’s note is usually two to three years. Overcoming things like the valuation gap can be challenging enough during a sale. While a seller note is one way to potentially bridge the valuation gap, it’s important for sellers to recognize that they may not receive the full proceeds from their sale for a couple of years after it is complete.
A Seller’s Note Can Help Finance the Sale of Your Business
As a seller, one of the trickiest parts of the merger and acquisition process is working with the buyer to find ways to come up with proper financing. Too often, valuation gaps exist and sellers don’t receive the amount of money they were expecting from a sale.
A seller note can help bridge the gap. However, as a seller, you must be careful during this process. You should work closely with your trusted team of M&A advisors to protect your assets and properly put a seller’s note in place.
If you’re looking for assistance with the sale of your business, be sure to contact the trusted team at Allan Taylor & Company. With more than 15 years of experience in the industry, Allan Taylor has the expertise you need to navigate the M&A process.