Optimal Seller Note Structuring for Leveraged Buyouts
Posted on: August 10th, 2021
Most leveraged buyout sponsors, be they private equity funds or independent buyers, are resourceful when it comes to creating self-funding sources of capital. When a buyer is paying the seller’s price, there is unspoken understanding that the seller will need to hold some level of deferred purchase price, to make the funding requirement more manageable for the deal to close.This deferred purchase price can be a seller note, rollover equity, or earn-out.
Leveraged buyout sponsors are wise to try to push as much purchase price into these vehicles as they derisk the deal and ensure long term alignment with the seller. Over 30 years of closing 175 middle market deals, we have found a strong correlation between the level of seller deferred consideration and the quality of the deal. Strong companies usually hold far less in a deferred purchase price than average companies will. When a seller is willing to hold a large part of the purchase price in a back end, it suggests an adverse selection problem. It also creates vexing structural issues that are often hard to overcome.
Most sellers will only finance your deal with a substantial note (>25% of purchase price) if they have a clear path to recovery and downside protection. This means they often require security and current principal repayment. They may ask the buyer to guarantee their note, which most buyers are resistant to doing. They also may ask for second lien on the Company’s assets, which the lender will not want them to have. The objective in seller note structuring is to solve for several variables of a simultaneous equation. Here are the keys to solving this equation and structuring your seller note optimally.
- The Seller note must have a back ended principal maturity – The seller note should not pay back principal until the leveraged buyout lender’s loan has been paid back in full. This means that the seller will only be able to receive interest on their loan if the lender’s loan is outstanding. Current seller note principal repayment causes the leveraged buyout lender to treat the seller note pari passu with their loan. If the seller note is properly back ended as to maturity, the lender will count it as equity contribution by the sponsor.
- The Seller note must be subordinated to the Lender through an intercreditor agreement – the leveraged buyout lender will allow the seller note to pay interest if the Company is performing. The lender will require an intercreditor agreement with the seller noteholder that addresses the rights and remedies of the seller noteholder in the case of a loan default. This agreement will specify that the seller note is unsecured and must standstill in the case of a default.
- The Seller Note Principal amount should be proportionate to the amount of cash equity being invested – non-serious sponsors believe they can put in 2% cash equity and have their seller hold a 30% seller note. Lenders do not accept seller note in lieu of cash equity. We have done many deals where the buyers invested 12% and the seller note was 20% to 25%. The amount of cash equity invested by the leveraged buyout sponsor must be significant and meaningful in the eyes of the lender. If the equity meaningfulness test is passed, then the lender will accept the amount of the seller note as equity, provided it is structured in accordance with points #1 and #2.