Here are the steps to getting a seller comfortable with the seller note and some concessions you can make to make the seller’s note more secure.

lmost every acquisition I do has some portion of the purchase price paid after closing (e.g., seller note, rollover equity, earn-out, or escrow/holdback). I have posted about why this is so important and how to structure a Seller Promissory Note: ; and how to structure a Forgivable Seller Promissory Note: None of that matters if the Seller is uncomfortable with a seller promissory note.

Here are the steps to getting a seller comfortable with the seller note and some concessions you can make to make the seller’s note more secure.

First, emphasize to seller that the purchase price is predicated on this structure and one way or another there needs to be something paid after Closing. Seller needs to have some skin in the game after closing and buyer needs to have recourse in the event of a misrepresentation about the business; actually recovering losses from a seller, post-closing is too difficult.

Second, let the seller know that while there are a few options for post closing consideration, seller note is the best.

The options: Escrow, Holdback, Earnout, and Promissory Note.

An escrow is paid by buyer to a 3rd party escrow agent at closing. While escrow may be most secure for a seller, the escrow earns very little interest. For the buyer, this means bringing more cash to closing and potentially reducing the purchase price. The Seller needs to understand that the promissory note allows seller to get to the highest possible purchase price.

Holdback is when the buyer keeps a portion of the purchase price, to be paid later. This is not preferred by a seller because it is in buyer’s full control. Earnout, similarly, is in buyer’s control and usually contingent on hitting performance metrics post-closing.

The promissory note is one of best options for both parties.

For a buyer using an SBA 7A loan, the note is even more powerful because a Note on standby (no payments or adjustments) for 2 years can actually count toward the buyer’s required equity injection limiting buyer’s downpayment.

For sellers, it defers tax to a future year, provides an annuity payment, gives seller interest on payments held back, and makes seller a debtor (much more secure position).

However, on almost every deal, seller worries: how do I know I will get paid my Note?

Last week a seller told me, “the check you don’t see is the check you never get.” My response: it depends on how secure the check is.

Here are some tools to make sellers more comfortable holding a note (in order of less to more onerous on buyer):

  1. Information Rights + Board Seat. Giving seller an observer seat on your board or information rights gives seller comfort they will know if the business is struggling. This is even more powerful if you give the seller a minority voting board seat. This will have virtually not impact on buyer.

  2. Security Agreement. A seller will often ask that their Note be secured by a Security Agreement. This will have to be subordinated to the senior lender or SBA lender, however it gives seller a second position on the business’s assets and the right to file a UCC-1 (lien) on the business’s assets. Thus, even if the senior lender approves a sale of assets, the seller must as well (unless the Seller Note is being paid off at the time). This creates some difficulty for buyer, but extra security for seller. In reality, it is highly unlikely that a seller will ever be able to foreclose on the assets without senior lender’s approval.

  3. Personal Guarantee. This can and should be its own M&A Monday post. Seller’s will often ask for a buyer to personally guarantee the Seller Note. They will say, if you are comfortable standing behind the business (and you are personally guaranteeing the SBA loan), why not PG my Note? I am resistant to this for many reasons, but sometimes this is needed to get the deal done.

  4. Subordinate distributions. Sellers will usually want any free cash to go to pay down their Note. Thus, they request no equity distributions while their Note is outstanding. They may also ask for no management fees to be paid until the Note is paid. I usually only agree to this in the event of a default on the Note. However, depending on the strategy, this may be doable for a buyer.

Finally, Sellers may ask for cross-default. This means, that if there is a default on the Note, the seller’s non-compete/non-solicit obligations (in the purchase agreement) fall away. I never allow this. The lender would never allow this. If the business is distressed due to economic conditions, the last thing we need is for seller to open up shop across the street and start competing. Furthermore, if the bank has to step in to take the business, it will not allow the prior seller to compete.

Sometimes there is a concern that the business will go under and seller will be stuck in a non-compete. I usually respond, if the business goes under there will be no one to enforce the non-compete.

Never agree to a cross-default provision.

On almost every deal I do, we succeed in getting a seller comfortable with a seller note. These tools above help achieve this.