Tuesday, May 29, 2012

Get Paid More with a Seller Note

Corporate Finance Associates Newsletter Q2 2012

By John Hammett, Managing Director
Minneapolis Office, Corporate Finance Associates
cash paid from selling company
Private company owners are always interested in maximizing the value of their company when they sell. … Sellers naturally focus on the nominal valuation of the company. But the value to the seller isn’t just in the price that is negotiated, but also in the terms of the deal. Experienced dealmakers know that the terms of the deal can drive the total valuation from the buyer’s perspective.

The natural inclination of sellers is to favor an "all-cash" deal: …However, this perspective overlooks an alternative that can increase the total value of the deal by 10% to 20%.

This alternative is a "seller note". The seller note means that the seller finances part of the buyers purchase with a promissory note or a loan back to the company. The seller agrees that a portion of the purchase price will be paid three to five years down the road, and he will receive interest payments on the face value of the note. Private Equity firms (financial buyers) have a strong preference for including seller notes as part of their deal terms.

The example of this is shown in the attached chart (FIG 1). The example assumes that the company has EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) of $2 million and that it would be valued in an all-cash deal at 5 times EBITDA for an Enterprise Value of $10 million (left column). It shows an alternative where the seller finances 20% of the Enterprise Value with a seller note at 9% interest (center column) and the difference in cash to the seller (right column).

Buyer’s Perspective
The immediate difference is that the value multiple for the deal with the seller note is 0.5 times … higher than the Typical deal. … There are two reasons why the buyer will pay a higher multiple for a deal with a seller note.

English: Diagram of DuPont analysis of return ...
English: Diagram of DuPont analysis of return on equity. ‪Norsk (bokmål)‬: Diagram over DuPont-analyse av kapitalrentabilitet. (Photo credit: Wikipedia)
The first reason is simple math. The buyer’s balance sheet (FIG 2) is composed of bank debt, the buyer’s equity, and sometime, a seller note. Each tranche of capital has a different cost related to it. Bank debt is relatively cheap, with Prime Rate at 3¼% and commercial loans at 6%. At the other end of the spectrum, financial buyers target a rate of return of greater than 25% on their equity investment. The seller note lets the buyer put in less equity … so the deal is more leveraged but still delivers the target rate of return on the equity. This works because seller note carries a relatively high 9% interest rate, but that is still lower than the equity that it replaces. The math works out so that the equity investor gets an even higher rate of return, even though the price paid is higher.

There is a subjective reason why buyers pay more for a deal with a seller note: comfort. … The seller who is willing to leave a seller note invested in the company gives the buyer great comfort that there are no hidden issues that might show up after the deal is closed. This is reflected in a higher price to the seller.

Seller’s Perspective
In this example, the seller gets a 10% higher enterprise value on the company with the seller note. Just as important, the seller gets an opportunity to invest 20% of the proceeds in a high-yield fixed income investment. … The seller note becomes the fixed income allocation of the portfolio. Its performance should certainly beat the returns from most publicly-traded debt securities.

Bottom Line
The seller is making a wise move by selling a private company that is a concentrated , risky, and illiquid asset, and re-investing the proceeds in a portfolio of other investments to provide for future living expenses and to preserve wealth. The seller note should be managed as a core part of that portfolio.
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