Seller notes are one of the most common components of business sale transactions. In simple terms, a seller note is a portion of the purchase price that the Seller agrees to finance. The Seller receives payments over time according to agreed-upon terms. Seller notes can be a great tool for Buyers and Sellers to bridge gaps in value/price, reduce the barrier to entry for a less capitalized Buyer, or help reduce how much money a Buyer needs to borrow to acquire the business. While seller notes are common, not all notes are equal. There are always many variables to consider.
There is not always alignment between how much a Buyer would like the Seller to hold as a note and how much the Seller is comfortable holding. Buyers typically would prefer a larger seller note to reduce the amount of cash they need to provide at closing. Sellers often prefer to hold a smaller note. It removes the risk of money tied to future payments.
Sometimes a small seller note, say 10% of the purchase price, can be a great way for the Buyer and Seller to share in the risk of the purchase. If the Seller is holding a note, Buyers may feel the Seller has a little skin in the game. The Seller may be more likely to pick up the phone or answer an email after the transition.
In a transaction that involves SBA financing, there are usually additional conditions or considerations around seller financing. As mentioned initially, the more of the purchase price the Seller is willing to finance as a note, the less money the Buyer has to borrow. The SBA requires a minimum 10% equity injection or down payment to finance a deal. This equity injection is calculated as 10% of the total project cost.
In the event a seller note is used as part of the equity injection, the seller note is required to be on full-standby for the life of the SBA loan. For example, if the loan is on a 10-year term, the note would be on full standby for 10 years. The seller would not receive payments until the beginning of the 11th year. In some cases, interest can still accrue over the standby period, but no principal or interest payments can be made during the standby period.
Buyers will sometimes request this in our deals as a way of minimizing their costs for getting into the SBA loan, but we always push back and strongly advise against allowing Buyers to use a seller note as part of their down payment. In our minds there’s no reason a seller should have to wait 10 years to begin receiving payments on their note.
Sometimes depending on the cash flow of the business and Debt-Service Coverage Ratio (DSCR), which measures whether cash flow can support all required loan payments, the bank will still require a standby period for the payments on the seller note. There are cases where the combined payments to the bank and the Seller, are too burdensome for the Buyer, resulting in the standby requirement.
In SBA transactions the bank also takes first position on their loan, and the seller note is required to be subordinate to the SBA loan. In the event a Buyer defaults on their loan payments, the bank will recover their loan first. The Seller could be in a position where they have no collateral left to recover their seller note. Sometimes the bank will have additional language further subordinating the seller note to any future loans between the bank and the Buyer. For example, if the Buyer takes out an additional loan for working capital, the seller note could get subordinated to the initial SBA loan and the new loan for working capital. This can add another level of risk to seller financing above and beyond the inherent risk of getting future payments from the Buyer.
We always recommend keeping seller notes minimal for our clients to get maximum cash-at-close and reduce future risk. A business owner has already taken on enough risk over the course of building and running their business, and the last thing they should worry about is risk during their exit.
Beyond SBA requirements, seller notes can vary widely in how they are structured. The percentage of the purchase price financed by the Seller, the length of the term, and the interest rate all play a role in shaping the overall strength of an offer. A larger seller note may make a higher offer price possible, but it also increases the portion of the proceeds that are dependent on the future performance of the business and the Buyer’s ability to execute.
The way payments are structured also matters. Some notes are interest-only for a period of time, with principal paid down later. Others include both interest and principal from the beginning, providing a more predictable repayment schedule. In certain cases, a note may include a balloon payment at the end of the term, where a larger remaining balance is due at once. Each of these structures affects timing, cash flow, and risk in different ways. As with all aspects of the transaction, it’s all negotiable.
There are also cases where seller notes are tied to future conditions, which are called forgivable seller notes. These notes can be reduced or eliminated depending on future results. In one example, the repayment of the note may be dependent on hitting revenue targets. For the sake of simplicity, let’s say $100,000 will be set aside as a forgivable note. The condition being the company’s revenue at the end of the next year increases by 25%. If this condition is met, the Seller receives the additional $100,000. If it is not, they forgo or forgive that $100,000. Another example may be where a forgivable note is set aside with the condition being a key employee remains at the company for the first year post-close. In this case the set aside amount of the note may be the cost it would take to replace the employee. If the key employee remains with the company for that first year, the Seller receives the additional payment. If the employee leaves within that first year, they do not. Again, all aspects of these notes are always negotiable.
Seller financing may seem simple at first glance, but the structure of the note can significantly increase or decrease the risk to the Seller. Our promise at the Business Seller Center is that our clients will be 100% comfortable and educated on all components of their transaction, and if they aren’t, then we’re not ready to close. If you are thinking about selling your business and aren’t sure where to start, get in touch with the Business Seller Center. When it comes to selling your business, there are no do-overs.