Forgivable Seller Note and Investor Ownership Percentages

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by a searcher from Harvard University - Harvard Business School
in Dallas, TX, USA

2yrs ago

Forgivable Seller Note and Investor Ownership Percentages

Does anyone know how a forgivable seller note interacts with common stock ownership percentages if you are raising outside equity? As a very simple example, if it is a 10M deal (5M Senior Note, 2.5M equity, and 2.5M forgivable seller note) but the seller note is ultimately "forgiven", do the equity providers own 25% of the common stock or 33% (assuming there is no "step up" in common stock). I am sure the answer to this is that it can be negotiated in several ways but I'm curious what is the more conventional wisdom/market terms around this. Thanks for any insight!

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reply by a searcher 2yrs ago
in New York, NY, USA

I do not recall ever discussing a deal where a searcher was voluntarily giving up some of their ownership simply because a seller note was forgiven. The whole purpose of the forgivable seller note is to decrease risks to the entire capital structure, including -- most importantly -- for the searcher. If your stake was going to be diluted by forgiving it, then the forgivability isn't really that potent in many situations.

I sense that the reason you're asking is because the company is "worth" $10mm at close and so you are trying to allocate the $2.5mm that was forgiven to the remaining parts of the cap stack. But that's not how it works. You don't, for example, re-allocate your percentage ownership whenever you make a principal payment on the SBA debt, so why would you do it when the balance owed on the seller note decreases? If the seller debt is forgiven and we assume the market value of the company didn't change, then the total equity value simply increases to $5mm. Since the debt is being forgiven, however, it is probably a good indication that the market value of the company actually decreased (due to lower earnings or some other seller note trigger), and therefore your equity value may have increased or decreased depending on how large the seller note amount that forgiven is vs the decrease in the market value of the company.

reply by an intermediary 2yrs ago
from The University of Chicago in Chicago, IL, USA

Forgivable Seller Note has no impact on equity whether forgiven or not. And you do not want to link the two in an SBA deal. When such note is forgiven, you reduce goodwill, so you do not have income recognition.