M&A Monday: How to Structure a Seller Note in an Acquisition.

The Seller Promissory Note is one of the best tools when structuring an acquisition. Seller notes are common on SMB deals and used strategically by independent sponsors and small PE.

Each Monday I post one lesson buyers or sellers of a business should know. I learned these tips representing top private equity groups and learning from some of the best M&A lawyers in the world. These are tips that can and should be applied to smaller buyers and sellers.

A seller note is when seller lends buyer (technically, buyer's newly acquired business) a portion of the purchase price to be paid back by the company in the future.

For a seller, it can result in a higher sale price after interest. For buyer, it can bridge a price gap.

The seller maintains post-closing exposure, so the seller is more likely to fully disclose issues and remain helpful to the business's growth.

Additionally (as described below), the note can be contingent on performance, offset indemnifications/working capital without an escrow, and count as an equity injection by a sponsor.

Here are the top considerations when discussing a note with the seller:

1. Secured, Unsecured or Personally Guaranteed. Notes can be secured by the assets of the newly acquired business, or personally guaranteed by buyer. In the worst case, seller can pursue the business's assets or the buyer, personally (usually liability stops at the business’s assets) (subject to a senior lender’s rights (see Subordination below)).

2. Indemnity/Working Capital Setoff. Post-closing, sometimes a working capital adjustment or indemnity claim needs to be paid (see M&A Monday: What if I buy a business and something goes wrong, link in comments). Instead of chasing the seller for payment or setting aside an escrow (which, sellers hate), buyer can decrease or increase the note as a result of a working capital adjustment or indemnity setoff.

3. Contingent. Notes can be contingent on the business’s performance. Meaning, if the business does not perform as expected, the note gets decreased or increased. Seller’s usually insist on information rights and operating covenants to ensure the business is being operated correctly. While, the downside is seller remains looking over the buyer’s shoulder for a while, a contingent note can be a powerful tool to confirm the business’s profitability post-closing. Note: with an SBA 7(a) loan, buyer can only decrease a note, not increase.

4. Subordination. The seller note will always be subordinated to the senior lender. If you include a note in your LOI, include subordination as well. Remember, a landlord in a sale leaseback acquisition will insist on subordination of the seller note.

5. Note on SBA Loans. A note is especially powerful when paired with an SBA 7(a) loan (an acquisition loan up to $5m). The SBA loan generally requires at least a 10% equity injection by the buyer. However, a seller note can count up to 5% (as long no payments for 24 months). In some cases (e.g., partial change in ownership), the note can count up to all of the equity injection (debt to worth ratio, 9:1). If it is used as an equity injection, it cannot be contingent or used for a setoff (3 and 4, above).