During one of my favorite deals ever, we reached that familiar point where there was a hole in the financing. The PE fund would only contribute so much equity and the senior secured lender would only go so far based on the collateral. When my client saw what the cost of mezzanine financing was (back in 2005), he said “I’ll do it myself!”
His rationale was simple. “Where else am I going to find a return on my money like that?” Besides, he would still be in charge of the Company going forward. He happily took an interest rate lower than the mezz funds (although still substantially higher than a typical fixed income investment) and saved himself the related equity component. It also sped up the completion of the deal (no due diligence needed for the present owner). In the immortal words of Nick Gilbert, “What’s not to like?”
For most sellers of closely-held companies, the decision is not quite so easy. Seller financing can be attractive, but also comes with its own set of risks. In this current market, however, with interest rates continuing at near record lows, it is a strategy that must not be ignored.
First, you must look at your own financial needs. In my example above, the seller was extremely well off financially and did not need 100% of the proceeds at the closing. Is that your situation? If you need all of the proceeds to reach your dream, does it make sense to risk deferring a significant portion of the proceeds, no matter what the interest benefit? This is still a loan after all.
Next, consider your position in the capital stack. It is time to put on your lender’s hat and ask some hard questions (recognize these?): What is the collateral really worth? Will I be getting a second lien? With the senior secured lender in front of me, how much is that lien really worth? Can the Company’s cash flow safely support both the senior loan and my seller note? Ironically, even though you think you have these answers, it may be prudent to get your accountant or investment banker to run the numbers and give you an objective analysis.
Now comes the time to discuss pricing. Most seller note holders take some discount off of the market mezzanine rates, but how much (if at all) depends on a number of factors. In addition to the underwriting issues above, one key question is what your role will be in the Company post-closing. Most sellers willing to accept some paper back in the deal expect to remain active in the Company for some significant period of time post-closing. In a perfect world, your employment agreement and your note would be the exact same length and termination of your employment agreement would trigger immediate note repayment. Unfortunately, the world that I know tends to have owners departing within 18 months of the closing, while the seller notes are usually 5-7 years long, with a balloon payment at the end. Can you live with the risk of not running the Company while your note is outstanding?
Finally, do you wish to remain entangled with your former business? This has both business and psychological components. On the business side, if you are looking at a new role in the organization, how hard will it be for you to enforce your rights as a lender? Psychologically, if you are really planning on moving on, do you want to monitor the Company for years after your ability to influence its performance ends? For many entrepreneurs that position would be beyond uncomfortable.
As a seller, you need to consider your tolerances for these variables. In the right situation, seller financing can be a real home run. In other cases, it may be unavoidable in order to get to closing, but understanding the pros and cons will help you negotiate better and prepare your expectations appropriately. Be sure to seek experienced and objective advisors who can guide you through the legal, tax, financial and human issues that accompany this technique. You might find that being a lender suits you in this next phase of your life.
Originally published in Crain’s Dealmaker Blog
Cleveland business lawyer
