Although merger and acquisition activity has decreased during the economic downturn and bank loans have become difficult to obtain, many small and medium-sized businesses are still being bought and sold. Some banks require buyers to invest more of their own money in deals as a condition of obtaining a loan. Therefore, seller financing has significantly increased to bridge the gap between a company’s sale price, the amount of investor funds and bank loans available to meet the purchase price.
In its simplest terms, seller financing means that the seller receives a promissory note from the buyer for a portion of the purchase price. Usually the note is payable over a number of years, and it may be tied to other conditions of the deal or linked to an earn-out (additional purchase price to be paid based on the acquired company’s future performance).
The Pros and Cons of Seller Financing
The single biggest advantage in taking back a note as part of the purchase price is that, in the current economic and lending climate, there may be no other way to get the deal done. Also, a deal may be made for more money than the buyer has immediately available or can borrow. Unless a seller is convinced a better buyer is just around the corner and ready to pay all cash at closing, there may be no alternative to providing seller financing if the seller really needs or wants to sell.
However, deferring payment of a significant portion of the purchase price has risks, including:
- The buyer may run into financial trouble and be unable to make the note payments.
- The acquired company may not perform well. If the buyer is counting on using the acquired company’s money to make the note payments and the acquisition is poorly managed, doesn’t meet financial projections, performs poorly or faces the loss of a major customer, the money to pay the note may be unavailable.
- A buyer’s guaranty or offer of collateral in support of the note may turn out to have limited, or even, no value.
- The note given to the seller will always be subordinate to the bank loan. This means that the bank will have to be paid in full before the seller can try to obtain assets from the buyer or even start collection activities.
- Depending on the terms of the purchase agreement, a disgruntled buyer may have the right to withhold or even cancel certain note repayments if the seller breaches important provisions of the purchase agreement.
Therefore, while much attention is focused on the buyer’s examination of the company or assets to be acquired, a prudent seller will do all it can to investigate the financial condition and prospects of the buyer and any collateral offered to support a promissory note. By making a medium or long-term loan to the buyer, the seller is acting as a second bank. The risk of non-payment–or the need to start an expensive collection lawsuit–goes way up, the longer one is obligated to wait for payment.
If you have any questions or would like more information, please contact your Davis & Kuelthau attorney.