Acquisition transactions involving privately held businesses often include some type of seller financing, which can take many forms and be structured numerous ways. Some of the more common forms of seller financing include:
- Seller Note—This is a promissory note from the buyer to the seller. The significant terms to be negotiated usually include the maturity date (when it’s due), amortization term (number and amount of payments), interest rate, guarantees, and collateral. Notes can be advantageous to a seller in that it may defer the taxation of proceeds from the sale.
- Excess Employment/Consulting Agreements—Payment for services are just that, but sometime a seller gets paid above and beyond the services they provide. These “excess” contracts pay part of the purchase price in the form of salary, wages, or consulting fees. The significant terms to be negotiated usually include amounts (how much), termination conditions, guarantees, collateral, offsets and reductions, term (how long), fringe benefits, and death/disability actions. Excess Employment/Consulting Agreements can be advantageous to a seller in that they may defer taxation of proceeds from the sale and allow the seller to participate in benefit programs for things like retirement plans and health insurance. They can also be beneficial to the buyer in that they can be a deductible form of purchase price.
- Earnout—These are contractual terms that pay contingent amounts based on various milestones. The significant terms to be negotiated may include amounts (how much), term (how long), milestones (triggers), and offsets and deductions. Earnouts can be advantageous to sellers because it often allows them to increase the purchase price if the business outperforms. Conversely, they can be advantageous to a buyer in lowering the purchase price if the business doesn’t hit expectations. Most often they are tax deductible to the buyer.
- Residual Equity Stake—This is where the seller takes an ownership interest in the buyer’s company or the company being sold, post-closing. The significant terms to be negotiated may include the size of the equity stake (how much), control characteristics (voting, etc.), earnings (dividends, etc.), and restrictions on sale of the stake. Residual equity stakes can be advantageous to sellers because it often allows them to increase the purchase price if the business outperforms. Conversely, they can be advantageous to a buyer in lowering the purchase price if the business doesn’t hit expectations. It aligns the interest of the buyer and seller to the same goal.
From the seller’s standpoint, an “all-cash” deal is the best possible scenario, but is often not realistic. There are generally five strategic reasons for seller financing to enter a transaction, which are as follows:
- Providing Financing to the Buyer—A buyer needs capital to finance the purchase of a business—either debt capital, equity capital, or a combination of both. If a buyer does not have enough capital to make the purchase, a seller may agree to support the transaction by providing some form of financing. Debt capacity, based on cash flow and collateral, will dictate how much a buyer can borrow to pay for the company. Whatever the buyer cannot borrow must come in the form of equity capital, which is most often cash. Seller financing can take the form of either debt or equity, depending on the situation. The reasonable amount of this type of seller financing can be determined by examining the debt capacity of the company post-sale, and determining the equity required to compliment the debt financing.
- Inability to Agree to Valuation—When a buyer and seller do not agree on the value of a business, a common strategy is to utilize the time value of money to bridge the gap. By extending the time to pay the purchase price, a buyer can effectively pay more in real dollars, but only their perceived value in present value terms. Alternatively, a seller can receive more purchase price in real dollars, even though the present value is less than the cash received over time. In theory, the present value of the consideration paid should be the same for both the buyer and seller, but because each may have a different required rate of return on their invested dollars, this strategy is an effective tool in bridging valuation disagreements. The reasonable amount of this type of seller financing can be determined by analyzing the value gap and the required return on investment of each party.
- Tax Motivations—A seller may be able to achieve tax benefits by deferring the payment of sale proceeds into future years when tax rates may be lower for them. Generally, a seller is taxed on the sale price when they receive the funds, but there are exceptions like ordinary income from depreciation recapture. A seller should consult with their tax advisor to determine the most advantageous amount and character of this seller financing.
- Seller Re-Investing in Business—When a seller receives the proceeds from selling their business, they must make investment decisions. In some cases, a seller may determine that re-investing some of their proceeds in the business they just sold fits into their personal financial plan. This strategy is often nicknamed “second bite at the apple”. Determining the reasonable amount and type of this investment should be analyzed with the seller’s investment advisor in the context of the overall personal financial picture.
- Security for Indemnifications—When selling your business, there are agreements involved. These agreements are typically called the definitive agreements—the main one being the purchase agreement itself. Found within every purchase agreement are things called representations and warranties, which are given by both buyer and seller to each other. They represent the things that each side says are true and correct and are backed up or “guaranteed” by indemnifications. If a representation or warranty is found to be violated, the indemnification amounts and procedures are designed to make the other party whole on their losses resulting from the violation. Collection of the indemnity can be a problem and is sometimes backed by cash in an escrow account or an insurance policy. If there is some sort of seller financing involved in the transaction, an “offset” can be another way of the injured party being compensated, avoiding the need for an escrow or insurance.
While seller financing of sale transactions is a useful tool in the right situation, terms can often be tricky to work out. Two of the most difficult terms to negotiate are:
- Guaranteed vs. Contingent—Sellers always want amounts to be guaranteed to ensure they receive the agreed upon purchase price of their business. Buyers will often hedge their purchase price by trying to make the payment of seller financing contingent on performance of the business post-sale, satisfactory owner transition, and indemnification for representation and warranties provided by the seller at closing (often called offsets). Seller notes are the easiest to make guaranteed, with employment/consulting contracts and earn outs less so. Guaranteed employment contracts can be difficult because the buyer and seller incentives can be misaligned, with buyers expecting performance and sellers not properly motivated. Earnouts, by their nature, are not guaranteed.
- Security / Collateral— An obligation can be either secured or unsecured. A secured obligation is one where the promise to pay as backed by some sort of asset that the seller can take ownership of to satisfy the obligation if it is not repaid. An unsecured obligation is one where there is no asset backing the performance of contract or repayment of the note. Security is typically granted in the form of a lien over certain assets, which can be a “first” whereby the rights to the underlying asset are primary or it can be a “second, third, etc..” whereby the rights to the underlying asset are behind someone else. Liens can be perfected immediately or be conditional upon the occurrence of a trigger event. Liens are often difficult to obtain when bank financing is involved, and often must be negotiated or subordinated to a lender. Other forms of security can be written guarantees provided by an entity (corporate guarantee) or by individuals (personal guarantee). Buyers are often hesitant to provide such guarantees as they may affect assets unrelated to the business being acquired, conversely, sellers view a buyer’s resistance to guarantees as a lack of commitment to the obligation.
What happens if the buyer does not satisfy their obligation under seller financing? It will depend on the type of seller financing and should be reviewed by an attorney to decide on the best course of action. Generally, non-payment of a seller note is a default and not satisfying a contract will be a breach, with remedies spelled out in the various documents. Sellers should be aware that simply having a default or breach can be the first step in the process of obtaining a legal judgment against the buyer, followed by collection efforts. The process of recovery can be long and expensive.
Ultimately, seller financing is great tool to work with to negotiate a sale of a business, but there are many nuances and pitfalls. The best way to achieve a favorable outcome is to ensure that the terms are reasonable to both sides. If a seller gets too good of a deal, that the buyer cannot afford or honor, then it was no deal at all and is a recipe for disaster. Thoughtful negotiation, along with arduous financial and legal due diligence is the best way to succeed in seller financing.