Seller Notes in M&A Transactions Explained in Simple Terms
Potential buyers may not always have enough capital to buy your business, but that's no reason to dismiss them. If you do so, you may lose your best buyer yet.
But how can you save the transaction? What do you do if you disagree with the sale price?
In today's guide, we discuss how you can use a seller note to sell your business faster and at the best terms possible, even if your buyer doesn't have enough capital.
As you are about to see, seller notes can be tricky, and you'll need M&A experts to help you structure and negotiate a favorable note.
You can work with us at Exitwise to hire and manage your team of M&A experts, like tax accountants, M&A attorneys, wealth advisors, and investment bankers.
Consult with us today to ensure a successful business sale at the best terms and sale price possible.
What Are Seller Notes in Business Financing?
A seller note is a written debt agreement through which a business seller agrees to receive part of the purchase price for their business in a series of future payments if the buyer doesn't have enough funds to pay the entire price at once.
As a form of debt financing, the seller finances part of the transaction by structuring it as an interest-bearing loan payable by the buyer in predetermined installments.
Seller notes are prevalent in small business acquisitions because they mutually benefit both the seller and buyer.
Importance of Seller Notes in M&A Deals
Here's why seller notes are important in mergers and acquisitions:
Bridging Valuation Gaps More Easily: A seller note helps reconcile the differences in business valuation and the upfront payment. For example, if you and the buyer value your business at $3M, but the buyer can only pay $2.5M upfront, you can issue a seller note of $500,000 to cover the difference.
They Promote Higher Deal Closure Rates: Seller note financing can incentivize buyers without enough capital to buy your business immediately, increasing the chances of a successful sale. Bridging the gap between your asking price and what the buyer is able or willing to pay helps close the deal rather than abandoning it.
They Promote Smoother Transitions: Since you remain financially interested or invested in the business as the seller, you are more likely to help make the transition smoother. You are also more likely to help in any way you can to ensure the new owner is successful.
They Can Facilitate Debt Repayment to Your Business Creditors: If your business has a loan the buyer won't assume, you can channel the periodic payments in the seller note directly to the creditor. In this case, paying the creditor will be equal to paying you.
They Demonstrate Seller's Confidence in the Business: Issuing a seller note can show buyers that you trust your business's future performance, which can attract more buyers and reassure them that buying the business will be profitable.
Seller Notes vs. Other Financing Options
Despite being a common practice, seller note financing is just one of the many methods of financing a business purchase.
Here's how seller notes stack up against different M&A financing options:
Seller Note vs. Equity Financing
In equity financing, the buyer offers the seller shares in the acquiring company in exchange for shares in the target company.
Equity financing in a merger of equals results in both parties having shares in each company. If your company has greater value, you get more shares in the buyer's company.
The similarity between equity financing and seller note financing is that the seller may be retained in the business in both cases.
Seller Note vs. Leveraged Buyout
In a leveraged buyout, the buyer combines both debt (about 90%) and equity (usually 10%). The method is common if the buyer doesn't have enough cash and/or equity to finance the purchase.
An LBO could be similar to a seller note model. In some LBOs, the exiting ownership may lend the buyer some funds for the purchase price, which will be repaid with interest.
Seller Note vs. Earn-Out - Key Differences
Seller note financing and earn-outs are pretty similar, but they differ in several ways:
1. Amount of Payment Deferred
In a seller note, both buyer and seller typically agree to a sizable down payment, and the rest of the purchase is deferred. In rare cases, the seller may agree to postpone the entire purchase price.
On the other hand, an earn-out typically offers the choice of deferring the entire purchase price or part of it. The down payment is not always a priority in an earn-out.
2. Pegging Payments to Future Business Performance
The deferred payments in an earn-out are pegged to the business's future performance. You may base them on specific financial metrics or operational standards.
In a seller note, deferred payments are rarely pegged to future business performance.
Only a few seller-financed business acquisitions tie payments to future business success based on operational milestones or financial metrics.
3. Interest
A seller note includes interest at a certain predetermined and agreed rate on all future payments because the deferred amount is structured as an interest-bearing loan.
On the other hand, an earn-out doesn't attach any interest on future payments since they are contingent on performance.
Note: Typically, seller note financing involves cash only because it's most suitable for smaller business acquisitions. However, in some situations, equity may be included as part of the purchase price or a security if the buyer defaults on the note.
Benefits and Drawbacks of Using Seller Notes
Using seller notes has advantages and disadvantages to you as the seller.
You can enjoy benefits such as:
Higher Selling Price: The total selling price is high because of the interest gained over the life of the note. The seller note interest rate is much higher than you would get if the cash sat in a bank.
Selling the Business Faster: The high flexibility in paying the note amount can incentivize the buyer to close the deal sooner to avoid losing the opportunity.
Ease of Finding the Perfect Buyer: Offering a seller note may widen your pool of potential buyers, increasing the chances of finding the best buyer for your business.
Tax Deferment: A seller note may help defer taxes on the business sale, spreading the liability over the duration of the note.
Liberty to Sell the Note: You may qualify to sell the business note after some time if you need the remaining payments in a lump sum. However, you'll have to forgo some of the money.
While these benefits are pleasant, the following seller note drawbacks may sour the deal:
The buyer may default on the note, and you may not recover the remaining amount if you don't have enough collateral.
Defaulting may lead to expensive and time-consuming legal proceedings as you try to repossess the business or get the buyer to resume payments.
You may need a third party to service the loan by collecting, crediting, and disbursing payments. The added cost can eat too much into the total sale price.
Seller Notes in M&A - Insights and Practical Applications
Given that the benefits usually outweigh the drawbacks, let's check out some practical applications and insights to consider if you decide to use a seller note.
Practical Applications of Seller Notes in M&A
You can opt for a seller note arrangement in the following scenarios:
When executing a buy-sell agreement between two business partners.
When selling the business to your management team as they may not have the required funds in full, yet they are an easy-to-find buyer you wouldn't want to lose.
When you want to increase your bargaining power to protect yourself against lower valuations. The note will be seen as a kind assistance, reducing the buyer's bargaining power significantly.
If you want to incentivize the buyer to retain you in the business.
When the buyer has limited financing and can't access enough through traditional financing,
Insights on Using Seller Notes in M&A
Here are some insights to consider when using seller note financing:
Include provisions in the note to protect your interests, such as maintaining key financial metrics, a given amount of inventory, or certain operational standards.
Conduct enough due diligence on the buyer. You can qualify the buyer in various ways:
Obtaining a copy of their credit report
Asking for a resume showing their previous business experience
Asking for evidence of their past M&A success
Hiring a private investigator (if needed).
Ask for some of the buyer's personal assets as collateral. Using personal assets as additional security can be a great way to ensure the buyer doesn’t default. They wouldn’t want to lose the non-business assets.
Ask for as much down payment as possible. The usual amount is 50%, but you can negotiate up to 80%.
Ask to remain on the lease throughout the duration of the note.
Request access to financial statements during the note’s duration to ensure the new owner is honest about the business’s performance and their ability to make your payments.
How to Use Seller Notes for Successful Business Transactions
As mentioned, a seller note can increase your chances of a successful business sale.
Here's what to do to maintain the chances:
Start with a clear and accurate business valuation since it forms the basis of the note. You can use our free Exitwise business valuation calculator to estimate how much your business is worth.
Structure and negotiate favorable terms of the note, including the interest rate, payment schedule, principal amount, collateral, and provisions for defaults or late payments.
Draw legal contracts that protect your interests and rights throughout the note's duration.
Manage the note effectively after the sale to optimize your returns and boost your M&A success rate.
Most importantly, you'll want to work with a team of M&A experts to help you structure, negotiate, and manage the seller note.
At Exitwise, we help you hire and manage your dream team of industry-specific M&A experts to maximize your exit.
We can connect you with top wealth advisors, M&A attorneys, investment bankers, tax accountants, M&A advisors, and even fractional CFOs.
Schedule a chat with our team today to optimize your business sale.
Frequently Asked Questions (FAQs)
Let's close the discussion with some questions about using seller financing notes:
What Are the Key Terms and Conditions of Seller Notes?
Most seller notes typically have the following terms and conditions:
The maturity date (the date the buyer will make the final payment so you can release any collateral)
Provisions for late payments or defaults, including remedies for such situations
Payment schedule, including the frequency and dates
The principal amount of the note (loan amount)
Provisions for remaining in the business
Interest rate
Collateral
Our team at Exitwise can connect you with the best M&A experts to help you make and negotiate favorable terms and conditions in the seller note.
What is the Typical Seller Note Interest Rate?
The typical seller note interest rate is 6% to 10% (general range across all industries), depending on the level of risk associated with the buyer or the transaction.
What is Seller Promissory Note Usage?
Seller promissory note usage in M&A refers to seller note financing since signing the note means the buyer promises to make future payments as agreed.
Conclusion
Seller notes are excellent when you want to reduce the time it takes to sell your business if the buyer doesn't have enough capital.
Besides, seller financing in M&A deals ensures you receive future payments on top of the lump sum down payment, which can spread your income risks further throughout the note's duration.
However, closing the sale successfully with a seller note can be tricky. You'll need the help of M&A experts to structure and negotiate the transaction well so that your rights and interests are protected.
When you work with us at Exitwise, we help you find the M&A experts you need to ensure you achieve the business exit of your dreams.
Chat with our team today to kickstart the process of a successful sale at the best terms possible.
