Selling Your Business – Practical Tips for Sellers – Part 2: Seller Financing

This is the second in a series of posts discussing the sale of a business from the seller’s perspective. In the first post here, we provided an introduction to this series and discussed the very basic consequences of structuring a sale as an asset versus stock deal. In this second post, we’ll discuss another deal structure issue, seller financing, which is very common in sales of privately held companies.

Seller financing simply means payment by the buyer of a portion of the purchase price through issuance of a promissory note to the seller. Typically, the buyer delivers a promissory note at the closing of the transaction for the amount to be paid later by the seller, in addition to cash for the amount to be paid up-front. From the seller’s perspective, there is (or can be) significant risk associated with not receiving payment of the entire purchase price when seller financing is involved. To minimize this risk (and maximize the likelihood of payment), sellers should consider the following:

How Much Seller Financing — how much of the purchase price is the buyer requiring the seller to finance? To state the obvious, the more of your purchase price that you finance, the greater the risk.

Creditworthiness — how creditworthy is the buyer? If you’re a seller and are providing financing for a portion of the purchase price for your business, then think like a bank. Do some investigation to understand the buyer’s creditworthiness and any past or potential problems. Ask for and review financial statements, projections, and business plans (preferably with your accountant) and check public records for liens, bankruptcies, tax issues, and litigation. You might also look into prior transactions done by the buyer to understand how those transactions were structured and confirm that all notes payable by your buyer were paid in full.

Security — will the promissory note be secured or unsecured? Ideally, the note will be secured, or collateralized by the assets or stock being sold and perhaps other assets of the buyer. However, often the buyer’s bank or other senior lenders may not allow collateral for your note. In that case, you will hold only an unsecured obligation of the buyer, which means, if things go bad, you get paid after all secured creditors and on equal priority with all other unsecured creditors.

Guaranties — consider asking for guaranties, either from a parent entity or from individual owners. This is particularly important if the buyer is setting up a new entity to effect the purchase. In that case, the entity probably has little capital so you should make sure the buyer’s parent entity is on the hook for repayment too. You don’t want repayment contingent on the success of a shell company that may be leveraging itself up with debt to do the transaction. It may also be appropriate in some cases to require a personal guaranty from the individual owners of the buyer, particularly when smaller entities are involved.

Relationships with Other Creditors — if the buyer has senior lenders, then you can count on your indebtedness being subordinated to that of the senior lenders through subordination and/or inter-creditor agreements. But be sure your subordination and inter-creditor agreements allow payments on your note as long as no default exists under the senior indebtedness and contain other reasonable limitations on payment blockages. Senior lenders (especially banks) are notoriously risk averse and won’t likely give you much room to negotiate but you certainly need to understand the terms of your subordination and inter-creditor agreements and make sure they are reasonable.

Other Note Terms — consider the terms of the Note carefully to maximize the likelihood of payment. Make sure your promissory note has customary terms defining defaults and the consequences of defaults, such as acceleration of the maturity of the indebtedness, default interest rates, etc. At the end of the day, your promissory note can only go so far in ensuring payment but it can at least make your buyer very uncomfortable in the event of a default, thereby encouraging timely payments.

Covenants — with respect to covenants, consider typical covenants in a bank loan agreement and think through what can reasonably be required in the context of seller financing in a sale of business. You likely won’t be able to negotiate all (or even many) of the same restrictions on the buyer’s activities that a bank would, but there are probably some covenants and restrictions that can be negotiated (e.g., you might not allow the buyer to enter into more purchases and take on additional seller financing with a maturity date prior to the date of your indebtedness). You should also include terms giving you ongoing access to financial statements and other information while your note remains outstanding.

Timing — with respect to discussion of all of these points, the earlier in the process they are considered the better from the seller’s standpoint. If the buyer requires seller financing and you haven’t already negotiated key deal terms (such as collateral for the seller financing), then be prepared for very difficult negotiations when they come up before closing. Many senior lenders will simply refuse to allow terms such as collateral if given the choice, so the prepared seller will make such terms a condition of accepting seller financing in the first place (at the letter of intent stage).

As this short post demonstrates, seller financing adds significant risk and complexity to the transaction for the seller in a sale of business transaction. Wise sellers will realize this early in the process and consider whether seller financing (or how much) is palatable early on in deal negotiations. If seller financing ends up being a deal point, then the seller needs to thoroughly evaluate the buyer and its creditworthiness and make sure the legal documentation and terms put the seller in the best position to be paid in full. The earlier seller financing terms are negotiated, the better (preferably at the letter of intent stage).

In the next post, we’ll discuss another common deal structure term, earn-outs.


© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

 

Casey W. Riggs About Casey W. Riggs

Casey Riggs is a corporate and business attorney who represents companies of all sizes, from startups to large corporations, and in all stages of the business life cycle, from entity formation through an exit event. Casey also represents many of his clients in estate planning and administration.

You can read more about Casey here.

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