What are Seller Notes?
Seller notes are useful tools that can help a person or entity acquire a business from a seller, even when they do not have enough capital available to them. There are a variety of different reasons why this may occur, but essentially, when there is a shortage of capital, the seller will write a seller note which will take the place of the remaining capital and must be fulfilled at a later date.
How do Seller Notes Work
Seller notes work very similarly to loans. However, there are a few key differences between them.
Firstly, seller notes typically have far higher interest rates than conventional bank loans. This is because they do not have the highest priority when it comes to being paid off. In other words, if the buyer initiates both a bank loan and seller notes in order to purchase a company, and they only have limited cash flow available to them at any given time, then they will be required to pay the bank loan first.
There are a variety of differences in seller notes, depending on the agreement that the seller and the buyer come to. Interest can be accrued or deferred, be compounded or not. Upon the date of maturity the full principal may be required, or payments may occur at set intervals.
It is important that you make sure you understand all the aspects of whatever seller notes you are being offered before accepting.
Example of Seller Notes
In order to understand seller notes better, let's look at a basic example.
Person A is selling their company, XYZ for $1 million, to person B.
For whatever reason, person B is only able to come up with 90% of the cost. Person A is willing to sell the company to them for $900,000 and a seller note which will act as a loan for the remaining 10%.
In this specific agreement, the seller note will have a maturity date of 5 years, in which the 10% interest can be deferred.
Different Types of Seller Notes
There seem to be three main types of seller notes. The differences between them all refer to the way in which they are paid.
Amortization
This is the simplest way of repaying seller notes simply because it is so similar to the way that most people are familiar with repaying loans. In this case, provided that the business has enough cash flow, a monthly repayment will occur.
Some of that money will go towards the interest, some of it will go towards paying down the principal amount. This will continue until the principal amount is paid down completely and accrues no more interest.
This is a very popular way of writing seller notes as it can almost be seen as a second loan, from a private lender.
Bullet Notes
Seller notes are also made up of two categories of bullet notes. Bullet notes refer to paying down the principle in a single lump sum at the date specified in the seller note, usually referred to as the maturity date.
However, the payment of interest can be deferred and added to the principal on maturity, or interest can be paid at given intervals.
In cases where interest is paid with the principal at maturity, the interest often compounds over time, leading to a far larger amount due at the end. However, if the interest is paid over shorter intervals it may not compound.
There is no clear indication as to which of the three types of seller notes is the best. It is up to the buyer and the seller to determine which suits the situation better, and will allow for the maximum benefit of both parties.
However, when purely looking at profit, it is in the best interest of the seller to either go with a bullet note which will allow for compounded interest, or to make use of amortization.
Seller Notes Pros and Cons
Pros of Seller Notes for the Seller
The pros and cons to the seller will depend on the business. If the business does very well - which the seller should be able to predict - then the seller notes will allow the business to be sold more easily. The seller can issue a sellers note as they are confident they will get repaid because the business does well. This means it will attract mroe potential buyers as the buyer will not need to have the full amount requried to buy the business as they can use the seller note to make up the shortfall.
Additionally, the use of seller notes can be seen as a sort of 'investment,' where the money increased greatly due to the high interest rate of the seller notes; even more so than the money would in a bank.
Cons of Seller Notes for the Seller
If the business were to fail - which is sometimes out of the seller's hands - then they may have difficulty collecting the seller notes. Most of the time, the seller note would default completely.
And, as mentioned above, seller notes do not have the highest repayment priority, which is reserved for senior debt such as bank loans. This means that the seller notes might go unpaid if there is not high enough cash flow in the business.
Pros of Seller Notes for the Buyer
Seller notes are an incredible sign of the seller's good faith in the company. By being willing to write a seller note, they are indicating the extent of the belief they have that the company will continue to be profitable.
Additionally, if the agreement states that the seller will be involved in the company for some time after the sale closes, then they will also be willing to assist the buyer in the field, in order to ensure that they receive their money, thus they can teach the new buyer about the business.
And, of course, the last pro is that the buyer does not have to pull out of the agreement because they were not able to gather enough capital in order to purchase the company.
Cons of Seller Notes for Buyers
The largest disadvantage that buyers have when agreeing to seller notes is the very high interest rate.
Depending on the profitability of the business, you may be able to pay the seller note faster than you expected and thus do not need to endure the interest for too long, but in cases where the cash flow is not what was expected and bank loans are paid first, the seller notes may accumalate large quantities of compound interest.
Another disadvantge is that you may also have to deal with the previous owner of the company still having some control until the seller note is paid off, in which case you may have some problems changing what you think is necessary in order to grow the company etc.
Seller Notes Conclusion
Seller notes can be a great tool that can be used to ensure that the sale of a company is possible, by allowing for a flexible amount to be paid up front, thus opening up the possibility of the sale to a wider pool of buyers. T
hey can also make the seller a large amount of money if the buyer is able to repay them successfully. However, it is important to keep in mind that seller notes are not without risk.
Remember that the key to managing your finances is to manage your risk at all times. It is important to consider all aspects of seller notes before you offer one, or agree to one, and to weigh up the likelihood of your business being sold without the seller notes, as well as the likelihood of poor management etc. which could be possible after the sale affecting the chances of the seller notes being fulfilled, or defaulting.
You might be also interested in What is an EBITDA Bridge? and What is a FIRPTA Certificate?
