Seller note terms on a stock sale with multi-year contractors

April 17, 2024

by a searcher from Michigan State University in Los Angeles, CA, USA

Would love advice on what to tie a seller note to for a stock sale where 65% of revenue comes from recurring revenue via multi-year contracts and the remaining 35% comes from project based work (avg. 3 month project cycles).

At this point the seller has agreed to the forgivable note being on standby for 3 years but we haven't nailed down what metric to tie the note to. Any thoughts would be greatly appreciated.

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Reply by a searcher
from American University in Fairfax, VA, USA

Here are a few thoughts and suggestions. Considerations for Forgivable Note 1.) Stability of Recurring Revenue: Since a large portion of your revenue is recurring, it provides a predictable cash flow, which is a strong point in favor of the business’s financial stability. Tying the forgiveness of the note to the stability or growth of this recurring revenue could be advantageous. Metrics could include maintaining or increasing the annual recurring revenue (ARR) or achieving specific customer retention rates over the next few years. 2.) Performance of Project-Based Work: Given the nature of project-based revenues, which can be more variable, setting performance metrics related to the growth or profitability of this segment might also be wise. Consider metrics like increasing the number of projects completed per year, improving profit margins on projects, or expanding the client base for project work. 3.) Overall Business Health Metrics: Broader financial indicators such as EBITDA (earnings before interest, taxes, depreciation, and amortization) growth, net profit margins, or cash flow metrics could also serve as reliable bases for the forgiveness terms of the note. These would reflect the overall health and efficiency of the business. Suggestions for Forgivable Note Terms a.) Revenue Milestones: Forgiveness could be phased based on achieving set revenue milestones over the 3 years. For instance, a certain percentage of the note could be forgiven for each year that revenue growth targets are met. b.) Performance Bonuses: Consider tying parts of the note to specific performance bonuses related to the efficiency and profitability metrics of the projects or contracts. Legal and Tax Considerations i.) Legal Documentation: Ensure that all terms regarding the forgivable note are clearly documented, including specific conditions under which the note is forgivable. This documentation should be prepared with legal assistance to avoid future disputes or misunderstandings. ii.) Tax Implications: Usually if a debt is forgiven or cancelled, a debtor must file IRS Form 1099-C, Cancellation of Debt. However, the structure of your deal might be such that if the note is forgiven based on the fulfillment of certain agreed-upon conditions, the usual tax implications of a cancelled debt might not apply. (What Mike has suggested) Discuss with a tax advisor the implications of note forgiveness for both the buyer and seller, especially around how goodwill and step-up basis might impact tax outcomes.

Have you analyzed the historical growth rates of recurring revenue, typical contract lengths, and renewal rates to assess revenue stability?

Have you reviewed the current profitability margins on project-based work and their trends over the past few years to understand project metrics?

Have you considered any specific concerns regarding change of control that might affect contract stability or client retention, and what existing provisions are there in contract agreements about a change in business ownership?

Have you examined whether there are existing debts or significant liabilities that the business has, which might impact the structuring of the note?

Reply by a searcher
from Kennesaw State University in Atlanta, GA, USA

Thanks for the tag, ^redacted‌.

^redacted‌, you've got a lot of great ideas here. If you have more context to share on the nature of those contracts or what specifically you may be trying to de-risk, it would help me provide more creative ideas for you.

A few thoughts: getting too nuanced on the wrong metrics in a note can have the opposite effect on de-risking. So, just be careful. Getting nuanced does have its place when thinking about the metrics that might have an exponential impact on the business (either on revenues, enterprise value, customer concentration, etc.). So, focusing on those exponential factors, along with things like total topline, should help you de-risk appropriately and potentially increase the odds of you getting the business at effectively a lower price. A few ideas:

1. If the recurring revenue drops X% over Y time (recurring revenue has a higher value multiple so if it drops even a small amount it can reduce the overall value of the biz a lot)

2. If total accounts churn X% (or by #) over Y time (if 2 customers leave, it could mean your concentration goes up 20% depending on how many accounts you have and their associated revenues which decreases the value of the biz for the next buyer/lender/capital partner)

3. If vendor prices increase more than X% over Y time (will impact margins and DSCRs. You're the new owner, will they give you grandfathered rates is the question)

4. If more than # or X% of staff quit over Y time (this hurts the biz in all kinds of ways)

5. If CAPEX of more than $X is needed within Y time (not sure what type of biz you're looking at, this might not be needed)

Then you have your more obvious ones like:

6. If total topline revenue drops X% over Y time

7. If Gross Profit (or some other margin) drops X% over Y time (but post-sale, margins are more tied to you than the previous owner)

My goal wasn't to suggest doing all of these but simply give you ideas to pick from. The more you add in, though, the less likely you'll get a deal done. Keep it simple, maybe total revenue and total accounts (logo churn). Also, add in some incentives (not tied to the note, separate agreement or something) but that can be negotiated at the same time you chat through the note so the seller sees you're not trying to ping them on every risk but also wanting to find ways to make them more money based on performance.

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