Why a Creative Exit Deal Structure May Be a Good Idea in Today’s Market —Especially a Seller Note
Most entrepreneurs dream of selling their company one day, and the dream goes like this:
“I received a call from a huge multinational strategic company. They offered me all cash at a number higher than I ever thought possible, and we closed with limited due diligence in record time.”
In today’s market, this “dream” is just that: a dream.
If you, as a seller, hope to achieve liquidity in today’s uncertain markets, you will need to be proactive, prepared, and willing to be creative. Thankfully, valuations are holding reasonably steady in the middle market, so your prospects remain good. What has changed recently, however, is the “structure” of most deals.
The structure can take many forms, but let’s focus on the four most-common consideration elements:
- Rolled Equity / Reinvestment (along with your acquirer’s equity contribution)
- Seller promissory notes or “seller paper”
I have listed these in typical preference for sellers moving from non-contingent to contingent compensation (i.e., a portion of the purchase price being held back until a later date, post-sale) and from lower risk to higher risk.
“Cash is king,” the saying goes. In this ideal scenario, the seller receives the entire sales price up front and may get to walk away with little extra work or risk on their part. Typically, though, there will be other structural concerns, escrows, representations and warranties, and possible holdbacks.
What typically happens in this case is that, in order to reduce risk and ensure aligned interests (as well as help finance a deal), many private equity buyers will ask a seller to roll equity from the purchase price back to the acquirer or, in some instances, back into the stock of the acquirer. The advantage of this approach is that you get continued access to the books and records of the company and often can negotiate preference at the sale with your acquirer; however, like all equity, your rolled equity or capital is at risk of total loss. It is important to evaluate the risk/reward factor here. However, having had perhaps 100% of the equity or risk previously and being sellable you likely have a comfort level with your equity position.
Earn-outs. (intentionally moved up for definitional purposes)
These are valuation bridges between buyer and seller. In uncertain markets, they are a critical component to adjusting for “market risk” or an oft too-rosy proforma growth plan. Earn-out can take on many forms based on revenue, and retention of customer but most commonly based on future earnings or the achievement of the proforma presented by the seller to the acquirer. (We will talk about earn-outs in more detail in a future post.)
Seller Promissory Notes.
A seller promissory note is a form of debt financing used when the seller agrees to receive a portion of the purchase price as a series of deferred payments, usually because the buyer does not have sufficient cash to cover the entire purchase price. Historically, seller notes have been used as a way to help finance and share risk in a deal, often as a bridge to getting a deal done while offering a seller more surety of proceeds (vs. earn-out, for example). In today’s market, where debt capital (leverage) is constricted (and, frankly, more challenging for many acquirers to obtain compared to previous market cycles), more sellers are accepting promissory notes from buyers in order to get their deals done. This structure has a few pros and cons of its own that sellers may want to consider:
- A seller’s note could be the difference in getting a deal done or not. Think big picture.
- With debt harder to obtain and interest rates rising, offering or accepting a seller note may have additional advantages:
- Use a seller note to increase your bargaining power and defend against lower valuations. The M&A Axiom: “Your price, my terms” (or vice versa), holds true in any market. Your ability to get a deal done goes up, and your negotiating power goes up as well, the more risk you are willing to take (i.e., a three-year seller note).
- As an investor or debt holder, you are financing the very thing you likely know best— your company.
- Bearing in mind the current market volatility, you might want to receive a “promise to pay” at 8% interest, for example, as opposed putting your proceeds into the market. You may receive a higher return rate, given the risk, than you can get elsewhere.
- Unlike equity, you will be in line as a creditor of the corporation. As such, you may be able to repurchase your own company if the new acquirer missteps or cannot meet debt service, often at a steep discount (of course subject to priority).
- Seller notes are typically subordinated to the senior lender involved in financing the deal for the buyer. Therefore, you are lower in liquidation priority should things go wrong.
- Sellers may prefer a buyer in these markets that “over-equitizes” a deal (i.e., more cash up front), versus relying on excessive leverage. This is because, in the end, the more debt in a deal (versus equity), the more risk of default. Striking that balance is key to all parties being able to sleep at night post-transaction; after all, your tolerance for risk may be less than your buyer.
- A seller note may give you additional insights into company performance and access to company information post-sale, if adequately negotiated. However, unlike equity, it does not give you much “say-so” about how things are run.
- Depending on your risk tolerance and the degree you want to be “done,” indeed, a seller note does carry some concern for many sellers as they can’t mentally be “done” until the note is paid off.
Remember the “dream” we talked about earlier? In order to achieve it for your exit, your perspective may need to change about the actual dream and what is most important to you. Is it really an “all-cash deal”? Or is the real goal liquidity, diversification of assets, and less worry about operating a business? This kind of honest reflection and strategic thinking can make the different between being able to sell now and make your desired exit and being forced to remain where you are indefinitely.
Merit Investment Bank is here to help. Reach out to discuss the best path for your company to grow and for you to build generational wealth through the recapitalization or sale of your private company. 253-370-8893 | Craig.Dickens@meritinvestmentbank.com