As featured in our Q2 2013 Capital Ideas Newsletter. An article by John Hammett, Managing Director of our Minneapolis office.
Why do we call seller notes “Magical Capital”? Because seller notes have different properties depending on who is looking. Buyers treat them as debt; banks think that they are equity.
The Seller Note
A seller note is a debt security that is issued by the buyer of a company to the seller as partial payment for the company. As a debt security, a seller note has a claim on the company’s assets before the equity owned by the shareholders, but the seller note is “subordinated” to the bank loans (“senior debt”).
To the buyer, a seller note is debt because they are borrowed funds, not equity. The buyer pays interest on the notes at a lower rate (10%) than the return the buyer will earn on his equity (25%).
To the buyer’s bank, a seller note looks like equity because in the bank’s eyes, the seller note is lower in priority than the senior debt. Yet company seller notes that are part of a 50/50 debt to equity ratio can look to the bank like it is only 30% debt to 70% equity.
The balance sheet of the fictional Waterman Company below shows how the buyer and the banker perceive each element of the capital structure:
Something for Everyone
Including a seller note in the purchase and sale of a company provides everyone with benefits:
- The bank likes seller notes because they increase the “junior capital” on the balance sheet, which makes the bank loans more secure for the lender and the bank regulators. The bank may even charge a lower interest rate because of the additional comfort they get with a seller note.
- The buyer likes seller notes because they are cheaper capital than equity. While the buyer wants to earn a return of greater than 25% on its equity, seller notes typically cost 10% to 15% in interest. The interest is also a deductible expense to the buyer. Buyers get higher return on their investment if the deal has less equity because a portion is structured as a seller note.
- There are three good reasons why the seller likes seller notes. First, taking some payment in the form of a note gives the seller a higher fixed income return than the seller can earn with other investments. Second, a seller note can improve the cash paid to the seller on closing. Lastly, a seller note often can increase the total valuation for the deal.
Why A Seller Note Is Particularly Good for the Seller
The initial reaction of a seller is to reject the concept of a seller note. Common sense says that “cash is king” in deals. On the contrary, in complex deals like the sale of a company, a carefully negotiated seller note can be a benefit to the seller who understands what it can do.
Here is more detail on the three points described above:
Higher Fixed Income - All sellers need to re-invest the proceeds they receive in a sale. Typical investment models allocate a portion of the portfolio to a fixed income investment like government bonds to reduce volatility. Today, 7-year treasury bonds yield 1.1%. A 7-year seller note can yield 10% or more to the seller. That difference in interest is worth $1.2 million or more to the seller on a $2 million seller note. This is a significant increase in the total valuation of the deal.
More Cash at Closing - It sounds funny, but having a seller note in the deal can improve the cash on closing. This is because the seller note can replace the standard escrow that is required by the buyer. A good dealmaker will offer the buyer an agreement to offset indemnification claims against the note so that no escrow is required and 10 to 15% of additional cash is not held back from closing. In addition, payment of principal on seller notes can be considered as “installment sales” and the capital gains taxes are delayed until the note principal is paid to the seller.
Higher Price - Adding a seller note into a deal can increase the price that a buyer is willing to pay. There are both quantitative and qualitative reasons for this. Buyers typically use return on investment (ROI) calculations to determine a price. An experienced dealmaker understands that a seller note that replaces 20% of the capital needed for a deal increases the ROI to the buyer by reducing the amount of equity capital the buyer needs to invest. Here’s the kicker: in a transaction that has a $10 million cash value, inserting a seller note of $2 million that reduces the buyer’s equity investment raises the total deal value to $11 million for the same return on the buyer’s invested equity. So, what would you prefer - $10 million in cash, or $9 million in cash plus a $2 million seller note that pays 10%? From a qualitative perspective, a buyer has more confidence in the prospects of the company if the seller is willing to leave some of his purchase price invested as a seller note. This increased comfort for the buyer subjectively increases the value of the deal and subjectively makes the rest of the due diligence process go smoothly.
Good for everyone
The table below shows the detail of why this is good for both the buyer and seller. In our example, the buyer gets a 2% higher return on invested equity, and the seller gets $1.6 million more after tax, and the bank is more content.
When it comes time to structure the sale of your business, consider adding a little “Magic Capital” to the equation.