Seller Financing - One Means of Getting a Deal Done
Corporate & Finance Alert
April 7, 2009
The business and financial motivations for doing M&A deals continue and, indeed, may be enhanced as a result of the current economic climate. However, the credit crunch in institutional financing pushes seller financing to the forefront as a means of closing the purchase and sale of businesses, regardless of a seller’s urgency to sell or the perceived bargaining power of the parties.
Traditionally, there are numerous reasons why sellers accept paper for a portion of the purchase price, including the following:
- the buyer’s need for a gap-filler between financing from conventional sources and the market price for a business
- the buyer’s willingness to pay full market price as a condition to the seller accepting a “stretching” of the payment over time
- a means of securing seller post-closing indemnification obligations
- a means of hedging against paying a purchase price premium in the case of financially-troubled or otherwise challenged target companies
- a means of providing a seller with the tax advantages associated with a deferred installment sale
- a means of forcing a seller to maintain some “skin in the game” where the buyer will rely upon seller’s management of the business post-closing
This article will examine the forms of seller financing, the business and negotiating issues associated with the various forms and the intercreditor issues which must be confronted by sellers holding deferred purchase price obligations.
Payment by Promissory Note
Where the purchase price is fixed, but a buyer is either unable or unwilling to finance payment of the price through equity contributions and conventional third party financing, a seller will be required to accept deferred payment of a portion of the purchase price which may, but need not be, memorialized through the delivery of promissory notes. Indeed, the only practical reason for the use of notes, as opposed to relying upon deferred purchase price payment provisions of a purchase agreement, is if the seller has been able to negotiate for the delivery of negotiable notes. In middle market transactions, this would be rare.
Under §453 of the Internal Revenue Code, as long as certain requirements are met, the seller will be entitled to installment sale treatment, meaning that gain from the sale will be reported as and when payments of the purchase price are received. Installment sale treatment is not available with respect t ordinary income assets such as inventory, most dealer property, accounts receivable, depreciation recapture, or a proportionate part of interests in partnerships or limited liability companies holding such assets. In addition, a tax will be imposed in an amount equal to a statutory interest rate on a portion of the deferred tax liability associated with an installment sale to the extent that a seller takes back installment sale obligations in excess of $5,000,000 in any year. Also, if a holder of an installment obligation pledges that obligation as security for a loan, the loan amount will be treated as a payment on the underlying installment obligation, triggering income equal to the gross profit percentage times the deemed payment.
The seller should bargain for interest on the purchase price represented by a “note” so that a portion of the purchase price payments are not recharacterized as interest for income tax purposes and reportable as ordinary income as opposed to capital gains. Of course, to the extent that the seller actually receives interest payments in respect of the deferred purchase price, such payments would be taxable as ordinary income.
Payment Based Upon Performance by the Acquired Business – Earnouts
Deferred purchase price payments structured as earn-out payments are contingent upon the acquired business attaining certain milestones or benchmarks during a specified period after the closing. The benchmarks used are typically net revenues, net sales, net income or some other formula developed to accommodate the nature of the underlying business, and whether the acquired business is being folded into an existing operating business.
Earnouts are utilized when there is uncertainty as to the value of the acquired business due to financial distress or other economic volatility and, as such, operate as a hedge against a buyer’s overpayment for an acquired business. Earnouts may also be utilized to reward a seller if an acquired business performs better than projected or as a means of incentivizing a seller retained to manage the acquired business after closing. In the case of the latter, particularly if an earnout payment is accelerated when a seller’s post-sale employment is terminated, there is a risk that all or a portion of earnout payments could be characterized as compensatory payments, as opposed to purchase price payments, and taxable as ordinary income as opposed to capital gains.
Earnouts may be structured so that there is a cap on the deferred portion of the purchase price. Alternatively, earnouts may be limited to a specified time period following closing, but otherwise uncapped in terms of amount.
Except as noted above, in most cases, earnout payments should qualify for installment sale reporting for tax purposes. Both buyer and seller should consult with tax counsel in connection with the structuring of earnout payments.
Common Issues in Seller Provided Financing
The seller who is under pressure to sell or otherwise lacks leverage in negotiating the transaction may have to accept a buyer’s mere promise to pay in the future without any form of security or other credit enhancement. Conversely, a seller who accepts buyer paper in order to close the gap between a market purchase price and available conventional financing, or as a bridge until conventional financing becomes more readily available, may command terms of seller financing resembling traditional third party loans with a full package of affirmative and negative covenants, an interest rate tied to the market risk being undertaken by the seller, the grant of security interests, including a pledge of the ownership interests in the acquiring entity, the provision of personal guarantees, the delineation of events of default and remedial rights.
To the extent that the seller receives security in a form which may entitle it to resume control of the business in the case of a payment default by buyer, the seller should also try to negotiate for protections to ensure that the buyer does not strip the business of all of its value. These could include covenants restricting compensation and other payments to owners, restricting the sale of assets and requiring the maintenance of minimum levels of working capital until the deferred purchase price is paid. A seller also needs to be mindful that a deferred purchase price provides a buyer with a means of recouping indemnification claims which could exceed a negotiated cap on such claims. While the seller may have a breach of contract claim against a buyer who seeks to cut a better deal for itself post-closing, the buyer has leverage because it is holding the cash.
Common Issues Associated With Earnouts
Earnouts may give rise to a myriad of post-closing disputes between the transaction parties. For example, if the principals of the seller will be managing the acquired business post-closing, they may focus on short-term goals in order to boost the earnout, rather than long-term development of the business. This could include taking on unprofitable work in order to boost revenues.
Conversely, the principals of a seller who are exiting the business should be comfortable with the buyer’s skill in managing the acquired business and negotiate for protections that the buyer does not use accounting techniques or charge the acquired business with unrelated expenses as a means of depressing earnout payments.
Accordingly, both the buyer and the seller need to be comfortable with the applicable earnout financial formula. Generally, a revenue-based formula will be attractive to sellers. A buyer may accept such a formula if it is comfortable that there will be little variability in the expenses associated with the revenues. However, a buyer is likely to prefer a net income formula as a better indicator of the performance of the acquired business.
A potential middle ground is a formula based on EBIT, earnings before interest and taxes, or EBITDA, earnings before interest, taxes, depreciation and amortization. This measure will reflect the cost of goods and services and administrative expenses, but subtract other expenses which may be based upon the buyer’s capital structure or the means by which the acquisition was financed. If the acquired company is folded into an existing enterprise, a seller may also need to negotiate to exclude compensation expense, other administrative charges not directly related to the acquired business and inter-company charges for services in excess of market rates.
The owners of seller who provide seller financing either in the form of deferred purchase price payments or an earnout will likely have to confront a demand by the buyer’s lenders for some degree of subordination of the deferred payments.
At the extreme, a seller may be required to defer receipt of additional payments until the traditional acquisition financing has been paid in full. More likely, a seller will be subordinated only if there is an existing or inchoate event of default under the buyer’s institutional credit facilities, or if the making of the deferred purchase price payment would give rise to an event of default.
While senior lenders will want to maintain control over the exercise of remedial rights against the buyer who is in default, a seller should negotiate for a finite standstill period, typically 180 days, after which the seller will be entitled to exercise its rights in the case of non-payment by a buyer.
A seller compelled to subordinate payments with respect to seller financing should also seek to put limitations on the depth of its subordination. These may include limitations on the principal amount of senior indebtedness, the interest rate on the senior indebtedness and amendments of the payment terms of the senior indebtedness which have the effect of putting the payment of the subordinated seller financing at greater risk.
A seller with a deferred purchase price in the form of an earnout will likely agree to subordinate to the buyer’s lenders only if the seller is under a compulsion to sell and has no bargaining leverage. From the seller’s perspective, earnout payments will become due only if the seller’s business performs well. Accordingly, a contractual subordination of earnout payments absent an event of default on the senior indebtedness should be a non-starter. Even in the case of a buyer default on senior indebtedness, the earnout seller will argue that earnouts are not indebtedness in the traditional sense and should not be subordinated when the buyer’s financial difficulties are attributable to factors unrelated to the performance of the acquired business.