The Many Roles of Seller Paper
In the lower middle market, sellers have become increasingly willing to accept a note for a portion of the purchase price for their companies. In fact, the smaller the deal, the more common this so called “seller paper” seems to be. Our experience, however, is that business owners do not always understand why seller paper is so important to the buyer. It seems as though advisors are simply telling their clients that they will need to help finance the deal and business owners are accepting that guidance at face value.
Why is Seller Paper So Important?
When it comes to deals for the smallest of companies, where buyers tend to be individuals who are in the market to “buy a job,” seller paper may indeed be needed to help the buyer finance the acquisition. In slightly larger transactions, however, buyers are more likely to have sufficient capital, but have other equally important reasons for using seller paper.
We see two principle reasons why buyers require the sellers to finance part of the transaction. The first is alignment of incentives. In short, if payment of a meaningful amount of the purchase price is dependent on the future creditworthiness of the company, sellers are generally more willing to put forth the effort necessary to transition the business to the buyer and to help the buyer work through any issues the business might encounter.
In larger deals, it is more common to seek alignment with an earnout or by having the seller retain a minority equity stake. In smaller deals, however, this approach can be problematic. Exiting entrepreneurs and the new owner-operators may refuse to partner with each other; sellers may need the cash to replace their salaries; and in deals financed through the SBA, these mechanisms are specifically prohibited.
The second reason is more pragmatic. In the event that the seller misrepresents the state of the business in the purchase agreement and the buyer has a valid indemnification claim, the note can be (i) the only source of leverage to bring the seller to the negotiating table and (ii) potentially the only asset that the buyer can legitimately expect to access for settlement of that claim. Additionally, the risk that future claims could reduce the size of the note is a powerful incentive for the seller to provide honest disclosure about the business during the due diligence period and in the purchase agreement.
Recommendations
As business owners have become more accepting of the role of seller paper in lower middle market transactions, negotiations have become less contentious. But we believe that the advisors can help the negotiations go even more smoothly by educating their clients about all the reasons buyers insist on seller financing. And when businesses have multiple owners, advisors can help their clients see a note as a way to manage their own liability. Faced with a future indemnification claim, for instance, it might be much easier for them to reduce the face value of a note than to chase each individual seller for his/her share.
Bootstrap Capital
If you are aware of business owners who would like to sell their companies, please consider introducing them to Bootstrap Capital. We are keenly in tune with the issues business leaders face when they decide to sell their companies, as well as many other nuances of transacting in the lower middle market. Bootstrap Capital is a patient counterparty and can be a constructive partner in helping sellers through the sale process.