Ron Kahn: Seller Notes – Panacea or Pain?

So you finally find this great acquisition – one of your targeted industries, consistent performance, great prospects and strong management team. Oh yeah, it does have a couple of blemishes – some customer concentration, for one, but you’re comfortable with that. What nags at you are the two owners who started the company and are very active in the day to day management of the company. During the acquisition process they continued to state that, despite making a lot of money off the sale, they want to stay active and grow the business. You think you believe them but you’re just not sure because if they decide to go fishing instead of to work…

And then it hits you – let’s get the owners to take back some paper! Simple, or so you thought.

The first step is deciding whether the owners should be rolling over in to a debt or equity security. As a buyer, you’re likely to prefer the seller roll in to debt so you can keep all the upside to yourself. But as a seller, despite the priority you get from having a debt instrument, you probably prefer to roll in as equity. The new company is either likely to be successful and meet all its obligations or crash and burn with little available for anything but the secured debtholders. If the odds of the company having value just through a seller note and leaving nothing for the equity seem remote, and if the capital structure the new buyers are putting in place is prudent, then a seller is likely to throw the dice and go for an equity rollover, instead of a debt rollover.

But that leads to the next set of issues – does everyone invest in the same equity security or does actual cash trump rollover equity? If it’s the latter, two (or more) classes of stock are needed. It’s not uncommon to see most buyers’ investment come in the form of preferred stock, with a payment-in-kind (PIK) dividend, to insure they get all their capital back, plus some marginal return, usually six to eight percent, before the rollover equity is in the money. And since this concept is often a hard one to convince a seller to accept, how the actual common equity is divided becomes another key issue. Finally, voting issues and other corporate governance issues can also lead to some interesting discussions between you and the management team of your new business.

So, you begin to re-think the situation and wonder if the sellers will continue to be interested if they roll some proceeds in to a debt security, rather than an equity security. But, unfortunately, that too brings up some issues. Of course the sellers want some current interest on their debt as well as some amortization but when you reveal to your lenders the exiting news that the seller is willing to roll in as debt rather than equity you’re dismayed by their reaction: if the seller note is interest-bearing debt it counts towards your leverage multiples and may merely replace the debt the lenders offered. And amortization gives the sellers a ranking that may result in the need for more junior debt rather than senior.

So, given all of that, you start to reconsider whether maybe it’s just easier to pay the sellers all cash and bring in new management after all.

Ronald Kahn is a managing director with Lincoln International. The opinions expressed here are entirely his own.