IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses.  The following blog has been provided by Lisa Forrest & Addie Roberge of Live Oak Bank (www.liveoakbank.com).

The Importance of Seller Notes When Buying a Business

Written by Live Oak Bank

As a lender who specializes in SBA loan programs to finance mergers and acquisitions, Live Oak Bank has the resources and knowledge to help small business owners prepare for their next business acquisition. When structuring an acquisition deal, a seller note can be an effective way to bridge the gap if the buyer’s preferred purchase price differs from the financeable portion of the sellers’ asking price.

In simplest terms, a seller note is when the seller agrees to take on a series of debt payments from the buyer. When a seller finances even a small portion of the deal, it shows the lender that the seller is confident in the new owner’s abilities and leadership. The terms of the seller note are negotiated between the buyer and seller; however, it’s important to involve a lender in the discussion early-on to ensure payment terms meet debt service and cashflow coverage ratios. The seller note can also be used to protect the buyer from material misrepresentations, or even key risks such as customer retention or customer concentration through carefully written claw back provisions. Robust and carefully structured seller financing can often make the difference in overcoming critical risk factors with the lender. It can be a win-win for all parties involved.

What is a performance-based seller note?

For added security to the buyer, a lender may suggest tying the seller note to business performance, which is also called a performance-based seller note. In this structure, obligations can be reduced if certain performance criteria are not met. This can be appealing to buyers as it reduces their overall risk since the seller still retains some “skin in the game.”

Here’s how a performance-based seller note works in real life:

Let’s say Peggy owns a manufacturing company and is ready to sell the business to retire. The business is well established and successful with strong historic cashflow. However, one of the company’s existing customers generates a large portion of the company’s revenue, creating a significant customer concentration risk.If the business were to lose this customer, for any reason, this would negatively impact the buyer’s ability to repay the loan. In order to reduce this risk for both the buyer and the lender, the deal can be structured with a performance-based seller note. Let’s say Peggy commits to a $2.88 million seller note. The payments on this note are tied to the performance of the business on a go-forward basis. This way, if the company retains this customer long term, Peggy will get all the payments on the seller note in a timely fashion. However, if the company were to lose this customer, the payments to Peggy would stop, leaving enough cash flow to cover just the SBA loan obligation. Once the business replaces this customer (or wins the customer back) Peggy will begin to get payments on the loan again.

When structuring a business acquisition, an experienced lender will understand the value and inherent risks of a seller note. When appropriate seller notes could be an ideal solution to ensure a deal gets done. Lean on the expertise of a lender like Live Oak Bank to guide you through the pros and cons of this alternative form of capital.

Lisa Forrest is the SVP Head of Sponsor Finance and a senior M&A finance professional for Live Oak Bank. If you have questions about the content of this article or any area relevant to search fund associated business acquisition financing she would welcome you to contact her at (425) 999-2042 or lisa.forrest@liveoak.bank.

Addie Roberge is a Vice President with Live Oak Bank specializing in financing for buyers acquiring privately held companies, family businesses, and owner occupied commercial real estate in Washington. If you have questions about the content of this article or any area relevant to business acquisition financing she would welcome you to contact her at (360) 510-1535 or addie.roberge@liveoak.bank.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.