Posted on: February 23rd, 2021
Seller notes are a very common part of middle market deals, as most sellers expect to leave some value on the table to attract a buyer. Most buyers have a bit of an unexcited, ho hum attitude toward them. They generally range from 10% to 20% of the deal value and are considered both a source and use of deal funding. Despite their lack of excitement to a buyer, seller note structuring is extremely important and can be a hidden weapon for a buyer when raising acquisition financing.
Seller Note Structuring in Acquisition Financing
Often seller notes exist in a grey zone of a buyer not wanting to overplay their negotiating hand, and a seller not wanting to appear too desperate to sell. Buyers will usually accept the notional amount of the seller note, say $2 million out of a $10 million deal value, but will not press ahead and specify terms that are advantageous to them on the note. The seller usually wants rapid repayment of the note, as well as a secured position of some sort. It is common to see buyers requesting a 2-year repayment of the note. Rapid repayment of a seller note is a structural problem for most acquisition financing lenders as they expect any seller notes to be repaid after their loan.
When a seller note gets paid before the acquisition financing lender, it inverts the usual seniority position and elevates the seller senior to the lender. This results in the acquisition financing lender having to consider the seller note as pari pasu with their loan, which stretches the debt multiple and the debt service coverage on the transaction. The best way for a buyer to deal with this type of seller expectation is to define their terms of the seller note as early and as explicitly as possible in the negotiation.
All seller notes should be required by the buyer to be unsecured, and subject to the subordination preferences of the acquisition financing lender. In plain English, this tells the seller that the bank is making a loan to give them most of their money, but the bank is calling the shots as to their note. All seller notes should also be set with a 5-year maturity and structured with no principal repayment until the maturity date. This 5-year term along with the full subordination advantages the buyer and allows them to present the seller note as deeply subordinated, permanent part of the transaction structure to the acquisition financing lender.
This type of seller note structure qualifies this layer of capital as equity in the eyes of the acquisition financing lender, and they will usually give the buyer equity credit for this amount of seller note. This does not mean the acquisition financing lender will do the deal only with a seller note beneath them as they still require a good cash equity contribution from the buyer. A properly structured seller note can provide a huge lift to buyers seeking to bootstrap their finite cash equity resources. Depending on the deal specifics, deals can get done with buyers putting in far less cash equity, by leveraging this valuable, hidden weapon layer.