August 18, 2014

Beware – Seller Note Financing

Filed under: Uncategorized — comparadungrp @ 7:48 pm

There are varying reports regarding the number of Baby Boomer owned middle market companies in the United States.  However, there is a consensus that many of them will be for sale.  One report states that there are 83 million Baby Boomers representing the largest single sustained growth of the population in US History.  It is also stated that this generation started and grew hundreds of thousands of successful privately held businesses.  Additionally, it is reported that going back to 2011 and forward to 2029, there will be approximately 671,000 middle market businesses worth an estimated $2.47 trillion to be disposed of during this period.

Because of succession issues, finding qualified buyers will be challenging and giving new leverage to buyers.  At the lower end of the middle market, sellers will have to decide among other things, whether to ask for an all-cash offer or decide to take back a note or provide some form of seller note financing.  This structure comes with some pros and cons:  if the seller expects an all cash offer he/she will in all probability be limiting the number of potential buyers and a reduced purchase price.  On the other hand, a purchaser who will make a higher offer utilizing a form of senior debt financing will probably ask the seller to take back a portion in the form of a note.  Furthermore, the financing institution may not be willing to finance the level the buyer is requesting, and thereby requiring the buyer to put in more equity or the seller to assume some of the risk in the transaction.  In the former situation, the buyer typically has gathered as much equity as available to him/her and is looking to leverage the remaining portion, either through the institution or the seller.

When the seller takes back a note he/she has immediately put him/herself at risk as to the payout of the full amount of the purchase price.  The question becomes how do sellers eliminate the risk of default and not realize the full purchase price of the company.  There is no sure fire way to avoid this risk if the seller truly wants to sell the company and move to the sidelines.  However, the more due diligence that is done can give one more comfort in reaching the full payout, but this does not provide a guarantee.  If the buyer is an accomplished business person with a history of successful operations, again, one can gain more comfort based on the historical operations of the person’s company.  However, if the buyer is a first time buyer, plenty of corporate experience, but no ownership experience, then the future is even less certain.

Adding to this burden, all of the collateral will be pledged to the financing institution and the seller note will be in second or third place depending on whether there is sub debt and/or mezzanine financing in place.  The long and short of this scenario is that all of the assets will be pledged, including those of the buyer (personal residence) and no collateral left for the seller

The best that the seller can do is to know the buyer as best as possible and make a business decision on the qualifications of the buyer and his/her abilities.

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