16 Sep Navigating the use and Treatment of Seller Financing as part of Deal Structures
Understand how deal structures that involve seller financing can benefit both buyer and seller when it comes to making the post combination financial plan an obtainable win/win.
Mike Harvath 00:04
Hello, this is Mike Harvath with our shoot the moon podcast, our 102 episode, broadcasting live and direct from revenue rocket world headquarters in Bloomington Minnesota. Revenue Rocket is the premier growth strategy and m&a advisory for IT services companies. And we’re here today with my partners, Ryan Barnett, and Matt Lockhart. Welcome, guys.
Matt Lockhart 00:33
Hey Mike how’s it going? it going last week of summer here. So, you know, things are winding down if the year is, you know, in the IT services business, we like to say that if you haven’t booked your year by now, boy, you’re kind of a little bit behind.
Mike Harvath 00:51
There you go, Ryan?
Ryan Barnett 00:53
Hey, thank you both for being on the call today, and just to set up our topic here, we want to talk about a form of deal structure that is really interesting for both buyers and sellers today, and specifically, what we’re going to call a seller knowledge or a seller promissory note. And this is a tool that’s used to help mitigate, mitigate some risk, as well as really kind of help alleviate some cashflow return. So to back it up a little bit here and talk about just deal structures in general, if deals get done, there’s typically a few components to that. And, Mike, just walk us through, what are some typical deal terms that you might see, thrown about your panting default when you’re looking at a potential letter of intent?
Mike Harvath 01:45
Yeah, so you know, to talk about the various components, you know, oftentimes, you’ll hear this term enterprise value tossed around and enterprise value actually is the best way, think about it his purchase price, right, assuming that you’re going to acquire another firm, or you’re selling your firm, that’s kind of the total consideration or total purchase price. And then there’s terms, and the terms have to do with how that purchase price is paid. And usually, those components are made up of a handful of different types of currencies, it’s probably the easiest way to think about it. There’s cash to close, of course, there can be earn up or gain share components, where you achieve a certain threshold of performance post close and then you get a way to think of it as a product progress payment and you can oftentimes enhance your sale price by kind of over performing on estimated forecast with an earnout or a gain share. There’s certainly a promissory note that can be issued by a seller. That’s kind of what we’re talking about here today, or what we call seller note, where the seller is technically the bank, but it’s a guarantee it’s an a guaranteed payment made by the buyer. And typically sellers are secured debtors to the buyer, essentially. So they have a security interest, and we’ll talk about how that gets collateralized in a minute. And then there’s also equity, of course, there’s the equity roll that happens from time to time, like you’ll take some of your equity in your business and exchange it for equity in the buyers business. That’s pretty common for private equity firms I’ll want you to sell in, especially if you’re gonna stick around and you oftentimes hear this term second bite at the apple and all that stuff. It’s really about, you know, rolling some of your select equity, if you will, your equity in your business into the new entity, with the goal that that new entity, with the proper capitalization and funding will grow to a place that you couldn’t grow your business alone. And then that portion of the equity that’s still owned, and the new company will be worth more in the future, and then ultimately, it’ll be a transaction, you know, oftentimes four or five times years down the road. But you know, it is part of a new structure or the buyers equity are the combined buyers and sellers equity.
Ryan Barnett 04:17
That really helps define it, Mike, and when we talk about enterprise value, help me understand if, Is there a relationship to the total enterprise value and the deal structure terms? For example, if you have something that sells more guaranteed, what happens to the enterprise value?
Mike Harvath 04:38
Yeah, that’s a good question, Ryan. So typically, if the purchase price is guaranteed, enterprise value is lower. And it’s just a risk reward kind of, you know, equation. If you’re a seller and you sell for all cash, that’s likely going to have the lowest enterprise value number. Because you’re as a seller not really taking any risks, right, you’re getting a check for the full value of your business, time of close, minus some, you know, reps and warrant holdbacks for escrows, which are common in these transactions, you’ll ultimately get that money provided you haven’t violated any, any reps or warranties, or statements you’ve made in your purchase agreement. But generally, that’s the lowest enterprise value, all guaranteed, but maybe not all pay to close is typically where a seller note comes in, where essentially, you may get a portion of the transaction in cash, and a portion in seller financing where you carry a note that the buyer has with you, and they pay you interest or carrying cost on that money, but you get progress payments, sometimes those progress payments come monthly or quarterly or annually, depending on the deal. But all of that is guaranteed. And that’s collateralized, meaning that if for whatever reason, that buyer would default on that note to you, you could call the collateral. And usually the collateral has to do with your your business assets. And that situation, or maybe even all the assets combined it, it just depends. But you know, we’ll talk more about that in a minute. And then as you move up to more risk associated with the consideration, usually the enterprise value goes up. So like, if you include an urn out, for example, enterprise value will go up, because there’s a risk that you may not hit that threshold or that urn out. Now, I’ll tell you, and we’ve talked about this a lot in our podcasts that you know, 86% of the time, earnouts get paid out at or above the index value, and if they’re structured properly, and so you have a pretty high likelihood to get into an urn out. So a lot of people like earnouts, particularly if they’re going to stick around and be part of the transaction post close, because they can assure and influence their ability in still running the company or driving sales for the business that they’ll hit their earnout targets over the next one, two or three years, which is typically our not so structure. And then companies that have equity in them. Oftentimes, the enterprise values are higher for a variety of reasons. And partially because you’re taking into consideration not only the risk of that equity, particularly if it’s not a public company that’s doing the acquisition, in the case of a public company, usually stock is pretty tradable and liquid, you may have a holding period, but that equity is fairly liquid so it looks like cash for the most part. But in a company, a private company, where you may have liquidity concerns or you’re being of not be able to get liquid on that equity, it certainly can tend to drive up enterprise value because you’re taking some risks.
Ryan Barnett 07:57
Yeah, so there’s definitely an equation on on the enterprise value, and then type of risk. And if you think about this a bit, sellers are going to want to really align their interests of what we would term selling in or selling out, and just want to confirm either of those are good option. But selling in maybe I think opens up options for equity, and really looking for fueling future growth together. And if you’re selling out, I think oftentimes you sellers have less control on the back of their business, and they are and more cash at close makes a lot more sense.
Mike Harvath 08:41
More guarantee, I would add Ryan that, you know, it certainly can be a combination of if you’re selling out, it should be more guarantee, which would be a combination of cash or seller financing, or seller note those are the same thing. Or when you’re selling in and going to work for the business for an extended period, you can take more risk, right, because you’re you’re at the table, you’re a party to the how the company will perform post close and can influence that outcome. So it’s more likely that if you want to run up your enterprise value maximize your sale price, that’s certainly a good way to do it If you’re selling it.
Ryan Barnett 09:22
Right, right. But if your seller’s looking to exit immediately, how would they how does the seller note fit in? Is this something that allows them to essentially kind of they have their own risk controls and the the buyer, this adds this adds a bit of a element for the buyer that’s helpful in mitigating some of the downside risks as well. Are there typically provisions with the seller notes? Can you say the business has to not go backwards or it has to hit a certain revenue threshold to make sure or that those payments are actually, they may or may not happen?
Mike Harvath 10:06
Yeah. So, you know, you certainly can put some conditions on a seller note and call it a conditional seller note, obviously, where as a buyer, you can get some risk mitigation there. Like, you know, the seller has to be competent enough in the business, for example, to say that the business won’t shrink at a post transaction, right, you know, and that’s an asset, it’s pretty common in the seller note to say, hey, we just don’t want the revenue going backwards from closing revenue, and it’s just another way to, you know, ask the seller to validate or fortify the health of the business. If that condition is met, that’s a common condition and a seller note, then the payouts will occur. Sometimes seller notes have those conditions, and sometimes they don’t, it just depends on the individual transaction. Best way to think about a seller note, is a seller note is like the seller, the company seller is like the bank, right, If you’re the buyer, you can get financing from the seller or in theory and get financing from the bank. There’s some advantages in getting financing from the bank, and disadvantages for the buyer. Certainly, the interest rate tends to be lower if they go to the bank. And then there’s advantages to seller because certainly they will get cash at close. But what occurs in that situation is, depending on the structure and size and complexity of the deal, the buyer may not be able to get all of that money and finance, right. It may constitute the seller, the buyer and the seller getting a little more creative and how they fund this thing. So generally, that’s when we see a seller note or a conditional seller note, is when they may not be able to either qualify for or don’t choose to give for whatever reason, depending on their debt situation, the full purchase price or majority of the purchase price from the bank. So what occurs is the seller then agrees to provide a note, typically, at a pretty material interest rate, 2% over prime is pretty common, but because of the risk profile, there’s a higher interest rate on a seller note than on a bank note, and that’s good for the seller, because they get to make an interest sort of carrying cost on their money that’s typically above other market investment opportunities, and sellers should think of it like an investment, I’m gonna invest and carry a note for this buyer, and I’m gonna get paid interest. They’re a secured debtor to the business. So just like, you know, they, they have security interests in the buyers business, and collateral. And so you know, usually to put these together properly, you need a, you know, confident m&a adviser, we certainly put these together on behalf of our clients all the time, but the components and moving parts of the seller knowledge need to be very deal dependent, and how it’s secured. And collateralized is critically important if you’re a seller, because you want to make sure that it aligns to your interests, particularly if you’re exiting the business. Not terribly uncommon for a seller note to be collateralized by the assets that you’re selling, as a seller of your business. The problem is, if the buyer defaults on the note, two years from now, and you’re already retired, and you now get your business back and some, you know, maybe not the best state or a state of which you left it, you know, is that okay with you, right, Is that considered an adequate collateralization mechanism. Now, keep in mind, they’ve already paid you cash and a portion of that seller not so maybe it is okay. But you just have to think through all those components on collateralization and payment terms and interest. That’s why having an outside adviser help you to assemble, it’s pretty important.
Matt Lockhart 14:23
Mike that is a really good point that do you combine a seller note with an urn out, or do you break those up, right. And what I mean by that is, say somebody wants to put conditions on a seller note, wouldn’t that be better to combine a seller note which doesn’t have conditions with an urn out period that is a gain share for both sides, so that it’s not a confusion between the two. And in that scenario, the seller has a vested interest in achieving their earn out in that same period that the seller note is active.
Mike Harvath 15:03
Yeah, that’s a good question, Matt. You know, every deal is different. As you know, situationally, it can be different for a variety of reasons. But yes, in theory, you could argue that, you know, a conditional seller note protects the buyer. Usually, the thresholds are set pretty long. So that it’s sort of a moonwalk easy for the seller to get to be able to make that condition. So the difference is like, hey, the business can’t go backwards is a pretty low bar in a growing business, right? Unless the buyer completely screws it up, they’re going to be able to get that seller paid out. And as a matter of fact, where we’ve proposed that, on behalf of buyside clients, I can’t think of one in 21 years, and we’ve done many, many of them, where the seller note hasn’t got paid out, meaning that the business shrunk below its size, when it was sold. It just it doesn’t happen that often. But your point is really important in that if you’re looking for upside as well, which would benefit the seller, because you have a lot of confidence in the velocity of the business, then yes, it’d be better to, you know, combine whatever cash to close with an unconditional seller note, and an urn out where there could be, you know, sort of an opportunity to participate in a gain share, where if there’s over performance or upside, which as I said before, 86% of the time, there generally is, then you can capture that upside or enhance purchase price as a seller.
Ryan Barnett 15:30
So is there a typical balance here? So and maybe ask them differently, will companies, I certainly just can’t see us representing someone on the sell side and recommending this, but do deals ever get done where they’re 100% seller note?
Mike Harvath 17:01
They do. You know, it depends on you know, usually those are unconditional type seller notes, or maybe there’s a portion that’s conditional, you know, it has a lot to do with the buyers financial condition. And I think when you’re thinking about that, it may also have to do with the sellers tax situation, right. So keep in mind that if you can defer some of this purchase price into a future tax period, which is what you do, when you carry a note, you can improve your tax harvest. So there are some I mean, we’re not tax experts, we say that all the time, but, you know, you can actually leverage a seller note to be more tax efficient in a transaction because you’re deferring into a future tax period where you may have a lower tax exposure. And so sometimes you see a seller that says, hey, I wanna I’m more interested in funding my retirement and I want to put in, this is an example of one of those, maybe it’s a family transition in you’re selling the business to your daughter or son, and you want them to be able to cashflow it in a way that’s meaningful, at the same time, you want to be able to fund your retirement. So you may say, I’m gonna give you a 10 year seller note funded by the business and collateralized by the business, and then I can fund my retirement or 15 year, whatever the note is, and I can get paid out gradually over time and you can take control the business as a family member and begin to operate it as if you, you know, I mean, technically you own it, you just carry a pretty material note on the balance sheet that you’re paying on and you’re paying interest, and so there’s situations like that come to bear where it’s 100%, seller note and then usually a situation like this, where it’s a, you know, family member transition type deal.
Ryan Barnett 19:03
I think that’s a great example, where maybe you have even employees that have been long term employees that are looking to sell the firm or the the owner would like to pass it on but has time and confidence in the team that they’ve instilled. It seems like a big interesting use of the seller note. Yeah. And just to understand, and by the way, you took my next question was do seller notes help with tax considerations and tell us absolutely there, there are some options there. Is a seller note typically, self financing through the success of the business? My question make sense? Is there adequate cash flow there, should this seller note be essentially paying for itself?
Mike Harvath 19:53
Well, ideally, but not always. And the reason I would say that is it depends on the term and the interest rate, right. And let me just go back one question a little bit because partner buyouts are also where a seller note to your point about employees, I you know not only family, you know transition, but partner buyouts are very commonly done with a seller note long tail seller note, if it’s long enough terms, and these are all related, right, if the term of the note is long enough, let’s say 10 years or, you know, five years or longer, depending on the profitability and growth of the business. Ideally, they should be self funding, I think in most situations where we’ve seen partner buyouts, and we’ve seen family member transition using seller financing, they are self funding, because they don’t want to burden the business in a way that would be untenable, right. And it’s in the seller’s interest to do that, because then they enhance their the likelihood that they’re going to get fully paid out. And this isn’t an uncommon position to take, particularly with other professional services firm buyouts, like in a case of medical practices, or sometimes accounting practices or law firms. Sometimes a partner buyout gets funded through these long tail, oftentimes, they’re positioned as retirement plans, but when push comes to shove, they’re really seller notes. And ideally, if you’re a buyer, you would want them to be self funding. Now, what I would tell you, though, is it still debt, right, it’s still on your balance sheet, and it’s not atypical for a seller note to be issued in a transaction and have a buyer want to have, you know, like a one two or three year conditional note, because they’re trying to get it paid off, right, it’s in their interest to sell or to get that debt service. So that they can, they can optimize and, and clean up their balance sheet. So in those cases, usually they’re not self funding by the contribution margin of the business, and they may need to pay, you know, depending on the terms as a monthly or quarterly or annually, or however it works, they needed to pay more than what the contribution margin would be to the business, it’s just again, somewhat situational, it would also depend on the size of the note, it might be a small note, there might be a material amount of money paid in cash that’s paid up front, maybe that cash came from the buyers balance sheet or came from the bank. So all those things sort of play into whether or not it would be self funding from the, from the profitability of the acquired business.
Ryan Barnett 22:46
That that makes a ton of sense, and there’s a, I just want to note here the promissory note can be typically there’s going to be a provision for the buyer to have the ability to pay off that note.
Mike Harvath 23:00
Yeah, for sure, you know, and a lot of them do, frankly, you know, if the combination is going swimmingly, and believe me, you’re not going to contemplate an acquisition as a buyer, or really even a seller, if there really isn’t this one plus one equal three, or very compelling reason to do the transaction where you’re going to be able to cross sell and upsell each other’s customers, and you’re going to be able to have all kinds of sallaries. So yeah, the base case for the acquisition has met, and or exceeded, because there’s just such great synergies, and it’s been an awful lot of cash, then most buyers on these kind of shorter term notes will pay them early just to clean up their balance sheet. And so it certainly happens quite frequently.
Ryan Barnett 23:48
That makes a ton of sense. And then the it sounds like the risk is mitigated for for the seller based on the collateralized of the business and the for the buyer, it gives another measure of risk, if there is some attainability metrics to make sure that perhaps there’s not less customer loss or there’s key employee loss, it can protect of that. But to add to Matt’s point earlier, there’s other options that are around potential earnouts or potential stock gaps to get some of those. You mentioned that the seller itself becomes the bank, not necessarily you don’t have to go to a bank to go to get this done. I’m assuming there’s some there’s got to be some kind of legal paperwork or is there anything that’s involved any regulated type industries when considering these?
Mike Harvath 24:36
Yeah, not really. You know, your lawyer will draft a promissory note that has all the usual legal protections in it for you. And it’s pretty much that simple. It’s part of the closing documents, and then you carry that notice as a secured debtor of the buyer. Big risks that a seller has is that buyer either defaults on note, and then you have to call collateral, or they go out of business. And if they do, you know, you’re in line with every other secured debtor in the business, so you have to weigh their, the health and wellness of the business, there’s some reciprocal due diligence that you need to do as a seller on the buyer, I mean, certainly when we represent sellers, we recommend that they do material diligence on the buyer, to make sure that they have the capacity to do the deal that they’re as they present themselves so that they can have enough wherewithal to pay the note, just like you would if you’re a bank, right, you go to a bank to get a loan, they do quite a bit of diligence on your business to determine that, it’s likely that you’ll be able to pay it back, you do the same thing and a seller notes situation, you do diligence on the buyer to make sure that they’re bankable, and that there’ll be likely they will pay back their note that they don’t have any, you know, pending litigation or judgments or have defaulted on, you know, other commitments, etc. in the past before you would ever agree to issue that seller note. But as far as you know, the document, it’s really a legal document, just like it is at a bank, right, when a bank lends you money, it’s really just a legal transaction with a promissory note and they sign it and they give you the money and begin to pay based on the agreement. Very same such you know, similar situation in a seller note context.
Ryan Barnett 26:25
It totally makes sense. Matt, do you have any follow up questions or anything else that you have in consideration for this?
Matt Lockhart 26:34
Well, you know, I think that this is just sort of one example of many, there needs to be a openness, and creativity wins in getting things done. To Mike’s point, I think it’s a huge highlight that the fundamentals of a deal need to be there, right, the cultural fit, the strategic fit, and the financial fit. And this is a creative option to enable the financial fit, but all of those pieces are absolutely crucial in getting the deal done. I think we’ve pretty well covered it.
Mike Harvath 27:19
Yeah, I think another comment I’d make about, you know, seller financing is that oftentimes it is the last, people don’t think of it immediately, but it’s something that may be needed to get a particular transaction done, particularly with smaller firms on both sides of the transaction, because in IT services and professional services, usually the single largest asset that owners have is the business. And, of course, banks are very interested in collateralizing, and mitigating their risks, while they do loan to business in the case of buyer, and they may just be out of collateral, right, depending on the size of the business or the scope of the business, and so at least from from the bank’s perspective, and having a little bit of creativity and flexibility, as a seller, you know, may allow you gonna get a deal done, with the seller note that the buyer couldn’t get done another way, or maybe you couldn’t get done as a seller. And if you see those synergies that exist, you can gauge that risk all entrepreneurs gauge risk every day, on the best ones they make, and hiring and sales and marketing and delivery and staffing, offices and everything else. This is just another way to look at a risk paradigm that may make sense for you to get liquidity out of your business, and ultimately, you know, move on to that next thing you have on your bucket list and life.
Ryan Barnett 28:54
Yeah, Mike, I do have one more question here, now that my memory serves me better. If there is a contingent note, It sounds like buyers would actually need to keep a separate set of books to on the success and health of the business that was acquired, Is that the case where you have to kind of keep measuring the business separately, or at least a portion of it?
Mike Harvath 29:22
Well, depends on the lever and the contingency, Ryan. So sometimes it’s you know, the business won’t go backwards revenue wise, then yes, I need to at least keep a separate set of books to account for that revenue during the contingent period, or note period. But it sometimes is contingent upon other things like that the seller doesn’t compete for a period of a certain length of time, or maybe it’s a headcount contingency where you can’t have headcount lower than XYZ, which which we’ve seen a few very rare situations but we’ve seen that, or it may be contingent upon a major customer being retained for a period of time that maybe the buyer has concerns about, in those situations require them to have a different set of books that would only only that they could track whatever that contingency might be either headcount or major customer retention or non compete or whatever. So I think the short answer on that is it depends on what the contingency is. If it’s revenue related, certainly, it would be important for profit related or some, you know, maybe it’s gross margin related, anything to do with Financials, it would require another set of books, but if it had a different lever, it might not.
Ryan Barnett 30:43
Thank you, that clears that up, I appreciate it. Well, that’s all the questions I’ve got today, and, Mike, I’ll turn it back to you for any closing thoughts and where you might take this.
Mike Harvath 30:55
Thanks, Ryan, and Matt. Hopefully, our audience found this to be an interesting topic today. As you guys know, will now tie a ribbon on it for this week at Revenue Rocket. We’ll be back next week for 103rd podcast, and we encourage all of you to come visit us at revenuerocket.com or if you have a question about this podcast or anything else as it relates to your IT services business, feel free to drop us a note at firstname.lastname@example.org Thanks and make it a great week.