Market terms for seller note and equity rollover/partial ownership

December 16, 2024

by a searcher from Iowa State University - College of Business in Denver, CO, USA

Hello,

I'm looking at a deal for a subcontractor business for about $4.5MM (2-3x multiple depending on historical average used) that has about $1.5MM of cash and $2MM of NWC on the balance sheet. For simplicity, I am considering a stock purchase transaction which would allow me to step into the balance sheet (assuming some pre-close distribution of cash) and keep the seller with equity ownership which is viewed favorably by the bank.

Does anyone have any general thoughts on the following (or thoughts/advice on subcontractors):

Seller note terms o How frequent are things like 2 year full standby or forgivable seller note in deals of this size and industry o What rate are folks seeing today – I’m proposing 6% as a starting point o If there is some type of standby on the front end and a 10 year term is it standard to have a ballon payment at year 8 or does is it essentially a 12 year note?

Equity Rollover o What is the typical amount as a % of equity that the seller retains? I’ve proposed 15% thinking it ends at 10%, I don’t think 5% is meaningful enough and I don’t think I’d want to get close to 20% o How long does this typically stay in place? I have proposed an option to take out after year 3 and then required to take out by year 6 o Any standardization of how valuation is calculated for takeout (e.g. average of 2 or 3 appraisals)? o What rights, if any, does the seller have on a go forward basis?

Reply by a searcher
from Massachusetts Institute of Technology in Apex, NC, USA

Devil is in the details but talk structure quickly - may be off here based on what you said but basically busines is cash + other working capital (3.5/4.5). If owner is rolling equity at 10%, he's getting a check for ~500k pre-close. If it's a 3x multiple - 1.5MM/yr that's few months of "work" for him. I'd make sure you're 100% aligned on what the transaction looks like - stock vs asset and because of so much working capital, what happens to that in a deal. I could see owner seeing his "net" and being like nah real easy driving up your broken deal fees and wasting time.
Most small deals are asset sales. Most multiples are debt free/cash free. If it's a subcontractor in a trade, I'd highly recommend asset sale - employee issues can come back years later. Workers Comp claims, unpaid wages, you name it. Yes you can paper lot of this but it's $$$ and you'd want to create an escrow/holdback...So owner now closes w/ 0 dollars because his check goes into escrow for 3 yrs.

PE likes rollovers around 20%, owner likely to be fine w/ less of a % as they cash out more now. I'd recommend just negotiating it all up front, e.g. you will buy roll over shares same multiple your purchased today in x yrs or of course dragged along if we sell to 3rd party who will determine price. He has rights of a shareholder - if you're doing stock sales that means whatever the opeating agreement or corporate bylaws say so you'd want to read them and ensure they don't change.

Reply by an investor
from University of Illinois at Urbana in Chicago, IL, USA

Thanks Luke. This is hard to summarize as it's all negotiable, but there are market standards and terms, specific bank needs, much depends on you, your background, net worth, etc. Would start with your lawyer on what's "market" for this stuff. But put yourself in the shoes of the seller. A bullet or int only note is much less desirable, but the bank won't likely want you to amortize and let $$ out while they have exposure. Unless they have tons of collateral. On the % roll, again - for a seller, the diff between 5 and 15% prob won't impact their behavior. How you behave will impact their behavior. Whether they view the equity and the note as having any real value also will impact their behavior. They need a good lawyer too so you make sure they understand all this.

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