Mergers and acquisitions can be complex financial transactions involving significant sums of money changing hands. In many cases, the buyer does not have the ability to pay the full purchase price upfront in cash. This is where seller financing can come into play.
What is Seller Financing?
Seller financing refers to when the seller of a business provides part or all of the financing for the buyer to complete the acquisition. Instead of the buyer obtaining a loan from a bank or other lender, they borrow directly from the seller to pay the purchase price over time.
The seller effectively provides a loan to the buyer. The terms are outlined in a promissory note and security agreement. This gives the seller an ongoing stake in the business and spreads the buyer’s payments out over a period of years.
Reasons Sellers Offer Financing
There are several potential benefits that motivate a seller to provide financing to a buyer in a merger or acquisition:
- Allow Deal Completion: Seller financing can enable a deal to happen that otherwise may not be feasible if the buyer had to get outside financing. This appeals to sellers who want the deal to close.
- Bridge Financing Gap: The buyer may be able to get some of the financing from a traditional lender but need the seller to carry part of the purchase price that the bank won’t fund. Seller financing bridges this gap.
- Interest Income: Carrying financing means the seller earns interest income on the unpaid balance over the term of the loan. This additional income stream helps offset taxes on sale proceeds.
- Belief in Buyer: If the seller believes in the buyer’s ability to be successful and pay off the loan, they may be amenable to financing as a show of good faith. This belief could be strategic or emotional.
- Facilitate Desired Sale: A seller may have reason to prefer a certain buyer they know or trust. Offering financing makes the sale more feasible for this preferred buyer and ensures the seller’s desired outcome.
- Competitive Advantage: In a situation with multiple potential buyers, a seller can make their bid more attractive to a desired buyer by offering favorable financing terms compared to what an outside lender would require.
- Transition Period: Financing can facilitate a smooth leadership transition after the sale by keeping the seller involved for a mutually agreed period as the loan is paid off.
- Tax Advantages: Structuring payments over time may provide tax advantages compared to receiving a lump sum payment, allowing the seller to manage capital gains.
Risks and Downsides of Seller Financing
Despite the valid reasons for seller financing, there are also several risks and potential downsides to consider:
- Default Risk: The top risk is that the buyer defaults on making payments as agreed. The seller must be confident in the buyer’s ability to repay the loan. If they default, the seller can repossess the business but a disruption is likely.
- No Bank Diligence: Unlike a bank, the seller does not do formal due diligence on the buyer’s finances. This information asymmetry exposes the seller to higher default risk.
- Opportunity Cost: Tying up capital in a private financing deal means those funds are not available for other investments. This represents a lost opportunity cost for the seller.
- Limit on Sale Proceeds: Carrying financing lowers the amount of sale proceed the seller collects upfront. This reduces funds available for retirement or other needs.
- Ongoing Involvement: Being the lender means the seller remains involved with the business. Some sellers want a clean break and so prefer an all-cash deal.
- Amortization: If the term is very long (e.g. 10-20 years), the buyer will owe substantially less in real economic dollars over time after accounting for inflation and the time value of money.
- Illiquidity: The financing provided becomes illiquid and difficult to convert back into usable cash until payments are made. The funds are tied up in the deal.
- Tax Issues: Interest income may bump the seller into a higher tax bracket. Higher taxes diminish the appeal of financing the sale.
- Contingent Liabilities: If the business fails, the seller as financier may be seen as contributing to the failure and share in liabilities.
These risks and downsides need to be carefully managed if seller financing is used. Let’s look at some specific steps and strategies sellers can employ to protect themselves.
Protection Strategies for Sellers Offering Financing
Sellers can incorporate various provisions in the financing arrangement to mitigate risks and protect their interests:
- Down Payment: Requiring a 20-30% down payment gives the buyer significant skin in the game and equity stake upfront while reducing the financed amount.
- Short Term: A term of 3-5 years is safer than 10-15 years for the seller. Shorter term preserves optionality.
- Amortization Schedule: Establishing a rapid amortization schedule front-loads payments to the seller, paying down principal quickly.
- Installment Schedule: Monthly or quarterly installments aligned with cash flows improve chances of repayment.
- Interest Rate: Charging a market-rate or slightly higher interest rate creates income buffer and incentive to repay quickly.
- Acceleration Clause: Including an acceleration clause allows the seller to call in the full remaining balance if payments are missed.
- Collateral Rights: Taking collateral such as business assets, real estate, or equipment secures the financing and provides recourse.
- Personal Guarantee: Requiring the buyer’s principals to personally guarantee the loan gives additional ability to collect.
- Financial Reporting: Ongoing access to company financial statements allows monitoring of performance.
- Milestones: Tying payment schedule to hitting revenue, profitability, or other milestones improves security.
- No Assumption Clause: Stipulating the financing cannot be assumed by a buyer if the business is subsequently sold prevents avoidance.
- CC Filing: Perfecting a security interest by filing a UCC-1 financing statement establishes priority claim on assets.
- Credit Insurance: Requiring the buyer to carry credit insurance covers default risk.
- Security Deposit: Requiring good-faith or escrow deposits provides further loss protection if default occurs.
Let’s take a closer look at one of the most effective options – taking and perfecting a security interest.
Taking a Security Interest
A security interest represents a contractual lien on the buyer’s business assets that the seller can claim and take possession of if they default on the financing. This right is enforced under the Uniform Commercial Code (UCC).
Here are key steps sellers should take:
- Specify Security Interest: The loan documents should indicate that a security interest is being taken and describe the collateral.
- Identify Collateral: The assets pledged as security for the financing must be specifically identified. Typical collateral includes inventory, accounts receivable, equipment, and intellectual property.
- Execute Security Agreement: Along with the promissory note, the buyer/borrower and seller/lender sign a security agreement granting the security interest in the collateral.
- Perfect Interest By Filing UCC-1: The security interest is perfected by filing a UCC-1 financing statement with the appropriate state office, usually the Secretary of State. This establishes the seller’s lien rights.
- Include Rights To Collateral: The security agreement specifies the seller’s rights to repossess, sell, and liquidate the collateral in case of default.
- Document Collateral Value: The seller should document the inventory, equipment, AR, and other collateral to establish its fair market value in supporting the financed amount.
By taking the appropriate legal steps to obtain and perfect a security interest, the seller ensures they have a claim to business assets that reduces risk and offers recourse if the buyer is unable to make payments.
Protections Mitigate Risk
Seller financing brings risks, but incorporating prudent protections greatly mitigates risk of default and offers recourse options. A carefully structured financing agreement benefits both the seller and buyer. Sellers should consult experienced M&A legal counsel to review terms before providing financing. With proper legal protections in place, seller financing can facilitate a liquidity event that might not otherwise be feasible for an acquiring buyer. Need help? Contact Scott Levine at [email protected] or click here to schedule an appointment today.
