In the coming months, be on the lookout for an increase in seller-financed mergers and acquisitions activity. 

For the last several years, the small and midsized business segment was experiencing increasing purchase price multiples fueled by low interest rates and the available credit made possible by banks’ confidence in a robust economy. Owners of solid businesses – motivated by a desire to close deals before anticipated possible changes in the current tax code – staged auctions and entertained multiple competing all-cash offers. Buyers took advantage of easy credit and low rates to deploy a combination of debt and equity, with debt on the portion of a deal supported by commercial real estate often exceeding 70%. 

The Federal Reserve raised the target range for the fed funds rate by 25 basis points to 4.5%-4.75% in its February 2023 meeting, dialing back the size of the increase for a second straight meeting but still pushing borrowing costs to the highest since 2007. By contrast, in February 2022, the fed funds rate was 0.25%. 

Banking Climate

With money more expensive, Lenders are demanding tighter covenants, lower collateral advance rates and materially decreased leverage. A survey of several Atlanta community and regional banks has seen Loan to Cost (LTC) and Loan to Value (LTV) metrics shift from a pre-COVID-19 range of as high as 75%-80%, to a current range of 65%-75% for Owner Occupied Commercial Real Estate (OOCRE) and 50%-60% for non-owner-occupied Commercial Real Estate (CRE) deals. 

Time Marches On

Increasing cost of capital has not stopped the passage of time for the owners of small and midsized businesses.  Owners who desired to sell have not developed new love for their companies. Owners who desired to retire have grown no younger. 

Creative Financing

Expect to see a rise of seller financing in 2023. Owners who desire to sell can expect to accept materially reduced purchase prices or to accept the risk of seller-financed payments over time. Some will choose to keep their businesses and continue to operate them. Some, however, will view seller-financed payments over time as no riskier than continued operation of the business itself, and will opt to sell. For them, seller financing may present an attractive alternative to holding onto a business or accepting a drastically lower sales price. For willing sellers, financing a deal represents a chance to extract a higher overall value as the economy moves on.

Seller-finance transactions may take several forms, including:

• Bridge Finance – The seller provides short-term financing for a portion of the purchase price, with the expectation that within two or three years the buyer will be able to obtain bank financing to pay the balance of the purchase price in a single lump sum.
• Subordinated Seller Note – If the buyer is able to obtain some bank financing, the seller may accept some portion of the purchase price in the form of a promissory note that is subordinated to the buyer’s obligation to the bank.
• Primary Seller Note – If the buyer is unable to obtain bank financing, the seller may accept some portion of the purchase price in the form of a promissory note that is the primary debt obligation of the business.

Because business owners are generally not in the business of evaluating credit or competitively lending, seller-financing vehicles frequently carry a materially higher interest rate. In addition to interest, for the seller considering such structures, some considerations:

• Bridge Finance – The seller should create a structure that incents the takeout. The form of promissory note is often a five-year or 10-year promissory note, with incentives for the buyer to pay off the note or replace the debt early in the term.
  • The seller may provide for interest escalators, or purchase price increases, if the purchase price is not paid in full within a relatively short time period, often two to three years. The seller often takes a first-priority security interest in the assets of the business and in the shares of stock or membership interests in the operating business, along with a personal guaranty from the buyer.
  • In addition, the seller may negotiate approval rights for major decisions, capital investment, cash distributions to the buyer or related parties, additional acquisitions, or other events.Such measures allow the seller to retain a measure of control, to prevent the buyer from taking risky actions without the seller’s knowledge while the debt remains outstanding.

• Subordinated Seller Note – The seller taking a subordinated promissory note is generally limited by the bank’s superior position and rights in its ability to influence the buyer. Because the bank will require a primary security interest in the assets of the business, the seller may be limited to:
  • A second-priority security interest in the business assets;
  • A first- or second-priority interest in the shares of stock or membership interests in the operating business;
  • The personal guaranty of the buyer.

  The seller taking a subordinated promissory note should anticipate an intercreditor agreement with the bank.  In essence, the seller taking a subordinated promissory note is relying upon the bank’s covenants and risk management to keep the buyer in line with respect to the operating business. In some instances, the seller may retain approval rights concurrent with those of the bank regarding major decisions, capital investment, cash distributions, additional acquisitions or other events.

• Primary Seller Note – The seller accepting a longer-term primary promissory note may desire to structure the transaction with an eye toward cash flow over the payment period, similar to an annuity. For the longer-term payee, the prospect of exercising rights under a security agreement and retaking the business or its assets years after stepping away may be impractical. For this seller, the notion of stepping back in to run the business again may be a non-starter. This seller may structure the payment stream to be manageable by the buyer and rely more heavily on personal guaranties and collateral that extends beyond the business assets themselves. This seller may also consider what happens to the stream of payments if or when the buyer sells the business.

In all three examples, buyer and seller must strike a balance that permits the buyer freedom to profitably operate and grow the business, while ensuring that the seller actually receives the financial benefit from building the business being sold. The remedies for failure must be both enforceable and practical. Technical legal rights that cost more to enforce than they are worth are no rights at all.

Creative and Thoughtful Bespoke Structures

In the current climate, room exists for bargains between sellers and buyers. Buyers must accept the risk of at least some absolute payment obligation in exchange for the potential reward of outperformance. Sellers may accept the risk of contingency of at least some portion of the purchase price in exchange for the potential reward of a greater absolute value if the buyer is successful. This is not cookie-cutter M&A. This is creative and thoughtful structuring, individually tailored for each situation.