Use of Seller Financing in M&A
Author: Gaurav Bhasin
We have had the pleasure of working with clients who have exited to prominent technology companies like Apple to Zynga. For them, cash generally is not an issue and they prefer to do all-cash deals for acquisitions vs. using their cash for paying dividends or share buybacks which can imply to public markets they see themselves as a value stock vs. growth stock.
There have been occasions where we have represented clients in a sale to portfolio companies of larger private equity (PE) firms (>$500M in AUM) or to mid-market PE firms as platform acquisitions where they have used a tool called “seller financing” (also referred to us as “I owe you” — IOU slips) to help get transactions over the finish line. Seller financing becomes an elegant tool for buyers to bridge the valuation gap to achieve the desired purchase price to consummate a transaction. We have also seen this done in acquisitions by private companies where they have used Seller Financing as an instrument to provide more attractive terms and be competitive with larger public companies who have significant cash.
Bank lenders to PE firms generally prefer to lend capital to companies which have EBITDA (for a lot of us in technology where we primarily focus on revenue growth given it is a key valuation driver and less on profitability; EBITDA means “Earnings before Interest, Tax, Depreciation, and Amortization” and is a measure of profitability) and will only do so unless the EBITDA is above a certain value (typically >$3M). We expect in the current environment lenders are even more swamped over concerns on credit defaults so expect banks to have tighter scrutiny and parameters on their lending.
This means PE firms who use leverage to get deals done are at a loss for leverage from lenders to finance deals or because the company they are acquiring may not have the EBITDA needed and hence ask sellers if they will be willing to use IOU slips with a promise to pay the amount due over a certain period of time. So for a deal of $50M from a buyer using sellers financing the structure could be $40M of cash and $10M of IOU slips (seller financing).
Sellers financing has several benefits:
- Removes the need for going to a bank which adds significant time to the process explaining to them how the business works so they can be comfortable lending against it
- Seller can get tax benefits from use of sellers financing and keep getting paid over time
- Allows sellers to negotiate a higher price and also affords buyers the ability to pay more via leverage from sellers financing
- In the current environment, access to broader debt market might be limited. Lots of companies are drawing down bank lines to strengthen balance sheet. Lenders are getting more cautious and borrowers need more capital in light of operational challenges
Considerations to think about:
- Seller should evaluate the credit worthiness of the buyer
- Understand what the debt stack looks like; is there a bank who is a lender on top who will have preferential terms and who gets paid first in a downside scenario and what protections are in place
- Limit the amount of leverage used in the deal for seller financing. We would suggest no more than 15–20% of the amount of the purchase price be allocated to seller financing
- Limit the time in which the sellers note is paid and also work out mechanics of acceleration of payments if certain operating covenants are violated
- Compare and contrast seller financing vs. other pay-out mechanism such as earn-out or management retention bonuses
We have executed transactions where the purchase price ended up being higher due to the use of seller financing and depending on the situation it could be an elegant financial instrument to get the transaction done. We would be happy to discuss your specific situation.
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About Allied Advisers
Allied Advisers is focused on Investment Banking for Entrepreneurs and Investors. Contact:info@alliedadvisers.com with presence in San Francisco, Irvine, Tel Aviv and Mumbai. A third of our transactions have been cross-border. Allied Professionals have closed deals in US, Asia, Canada, Europe, India, Israel, and South America.
