Seller Financing in Lower-Middle Market M&A: Why the Bad Rap?

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While seller financing can be a critical source of funds in a mergers & acquisitions transaction, sellers are oftentimes averse to the idea.  Quite frankly, I think it’s the wrong conclusion.

The argument of the sell-side is that a clean break from the business is desired and all cash at closing will allow that to happen more easily.  But, the truth of the matter is that a seller will oftentimes be tied to the business with some form of an employment or consulting agreement for a period of time post-closing.

Another argument of the sell-side is that the buyer will essentially acquire the business with the seller’s money through the use of a seller’s note.  While in actuality this statement is correct, my response is so what, as long as the magnitude of the seller’s note is not egregious.  I would never permit one of my sell-side clients to be invested in the transaction more than the buyer.  If this remains true and a third party lender is introduced at or near the customary 75% loan to value, then we’re contemplating seller financing of approximately 10%-15% of the value of the transaction.  This level of investment by the seller not only assists the buyer in completing the transaction by filling a funding gap, it demonstrates to all the other parties the seller’s belief in the company as a going concern. 

Finally, the most common argument of the sell-side against a seller note is the seller’s fear of remaining invested in the company after giving up control.  A seller note is debt.  The buyer is agreeing to pay the money upon certain terms and conditions, none of them being performance based.  A performance based loan would be an earn-out, a different subject matter with a different risk profile.  A seller note is simply money that is agreed to be repaid as long as the company is solvent, same as with the bank debt.

With that in mind, I submit to you that the seller note should be viewed by the seller as an investment.  The funds are being borrowed by the buyer in exchange for a fee, the interest rate.  The interest rate charged will be higher than the senior debt since it is in second position, ideally resulting in an above average return for the seller.  The seller is able to leverage the return off a larger investment since the money is pre-tax.  Should the seller extract these funds from the transaction, they would at a minimum be subject to capital gains tax before being reinvested by the seller into another business, real estate, or more probably, the public markets.  If the funds are earmarked for reinvestment in the public market, I would argue that the funds would be better off invested in the company being transacted.  The seller will struggle to identify an investment with higher fixed returns than the rate that could be achieved via the pre-tax investment of the seller note. 

Seller notes don’t deserve the bad rap they are oftentimes given by a seller in a transaction.  If used properly, they can provide a solid and steady investment level return post-closing.