Why deal-makers prefer seller notes for company sales?
Definition of Seller Note:
A seller note is a form of debt financing used in small business acquisitions. The seller agrees to get some money back for financing the company’s sale – receive a portion of the asset purchase price as a series of installment payments. Usually, the seller agrees to accept a portion of the purchase price in a series of deferred payments because the business buyer does not have sufficient cash to cover the entire purchase price.
A seller note allows the seller to get some money back for financing the sale of the company. The financing is used for funding the difference between the price at which the company is purchased and the asset base of the company, which can be financed. If a company does not have adequate assets, which are securities for older debt, the company buyer will offer the seller a note which is specifying the rate of interest and also terms of repayment. This method of funding a company sale ensures that the seller is financing part of the sale or the entire sale.
When companies are being sold, dealmakers will often describe the Seller Notes as Magical Capital. This is because the different parties in the deal will treat the seller notes differently based on their role. The buyer will consider it as debt while the bank considers the seller’s note to be the seller’s equity.
Explanation – seller note and private equity
Usually, seller notes are not secured and have a lower priority compared to senior debt. This makes the debt riskier, and a higher interest rate has to be paid. Some smart company buyers will market the seller notes to the sellers as a better option since the interest rate is better than the typical market rate for debt with a similar maturity period. The seller who is having the seller note should ensure the interest rate is high enough to compensate for the risks he is taking, as the company’s possible inability to generate enough cash flow to pay off the debt and the company’s risk profile. The seller should specify a repayment schedule for the principal. If the buyer is unable to repay the principal, the seller should be allowed to convert the debt into equity by exercising a debt-equity conversion clause.
A company buyer issues the seller note to the company sells to pay for the company partially and is a debt type of security. Like other debts, the seller note will have a higher priority claim on a company’s assets than shareholders’ equity. However, bank loans, also called senior debt, are given higher priority than the seller note. The buyer has borrowed funds from the buyer while issuing a seller note, and they are not equity. Typically a buyer will get 25% returns on his equity investment and pay lower interest on the seller note issued at 10%.
Benefits of the seller note
All the organizations and individuals involved in the sale and purchase of a company will benefit if a seller note is included.
– The bank handling the company business prefers a seller note since it increases the low priority capital listed in the balance sheet. The bank loans appear to be more secure for both the bank and banking regulators if a seller note is provided. Since the seller note reduces the risk, the bank may often charge a lower interest
– Buyers also prefer seller notes since they are a cheaper source of capital compared to equity. Most company buyers wish to get more than 25% returns on their equity investment and pay only 10-15% in interest on seller notes. The buyer can also deduct the interest as a business expense. Hence if a company purchase deal is structured so that a part of it is a seller note, the buyer will get a better return on the money invested.
– Sellers prefer seller notes for company sales for multiple reasons. The seller will get higher returns for his debt income than most other investment options. It will increase the amount of cash that the seller will get for sale. Often the seller note increases the total valuation of the deal.
How sellers benefit
Many business owners who are selling their company may only prefer outright cash payment and reject the concept of a seller note. Yet for complicated deals like selling a company, there are many benefits for a seller who understands the benefits of a seller note, which are discussed below:
Fixed income is higher: All business owners who receive payment after selling their business will have to reinvest it. Most investors will diversify their portfolio to reduce the risk, investing part of it in fixed-income investments. Typically government treasury bonds for 7 years have an interest rate of 1.1 %, while a 7-year seller note will give 10% or more interest to the seller. This will significantly increase the overall value of the deal.
Higher value at closing: Usually, while selling a company, escrow is required to ensure that the sale is completed as promised. This reduces the amount received by the seller. If a seller note is provided, no escrow is required, and money is not withheld. Additionally, when the buyer is paying the principal specified in the seller note, it will be considered an installment sale. Hence the seller can delay payment of capital gains tax till the entire principal is paid to the seller.
Higher price: The buyer is usually willing to pay a higher price for a deal if the seller agrees to accept a seller’s note. This is because the buyers calculate the return on their investment (ROI) to determine the price they will pay for a business. A deal maker who is experienced understands that a seller note will reduce the amount of equity capital that the buyer will invest. Purchasing a business is always risky for the buyer; hence, the buyer will have more confidence in the company’s future if the seller is willing to keep part of the company’s purchase value as a seller note. If the buyer is more comfortable with the deal, the business’s due diligence procedure will be easier, and the buyer may pay more.
Hence while structure the sale of a business, the business owner should accept a seller note for the reasons listed above to get a better deal.