Seller Promissory Notes:

Does the seller need to seller finance a portion of the purchase?

• For the vast majority of the acquisition loans we do, the seller doesn’t"need" to finance any portion of the purchase.
• Sellers “can” seller finance any amount of the purchase with a promissory note but have to subordinate that note to the lender’s note.

What are the primary examples of when seller financing may be needed?

• W2 advisors, advisors without production, and advisors whose practice has too low of a value compared to the seller practice value being acquired.
• If the deal isn’t cash flowing strong enough or the lender has other concerns about the deal, the lender may require the seller to finance a portion of the purchase. In these cases, a 20-25% seller note is the typical percentage the lender would require.

The seller can finance my 10% SBA equity injection requirement?

Most of our advisor clients that choose an SBA loan satisfy the SBA’s equity injection requirement without having to come out of pocket for a cash down payment.

For SBA acquisition loans where the combined practice values do not meet the SBA equity injection requirement, a 10% equity injection must be made by either a 10% cash down payment from the borrower, or if the seller is willing, a 10% seller promissory note that is on full standby for two years. The promissory note can accrue interest, but no payment (principal or interest) can be made for this note during the standby period.

Do all seller promissory notes have to be on “standby” for the life of the SBA loan?

The only seller note that the SBA requires to be on standby for the two year standby note as part of the SBA equity injection requirement. "Standby" means that while interest can accrue, no payments can be made to the seller while the buyer/borrower’s SBA loan is still active.

If the seller did "inject" 10% of the equity with a seller note that is on standby, any additional seller note would not be subject to the standby rule. For example, a seller can have the 10% seller note on standby but have another 20% seller note that is paid over 5 years.

Do all seller promissory notes have to be subordinated to the lender?

For bank financed deals, both SBA and conventional, the lenders we work with will require the seller to subordinate the promissory note. It doesn’t matter if the bank is financing a minority or majority of the purchase price, a subordination letter will be required for most every acquisition loan. The lender provides the subordination letter that must be executed by the seller. However, our lenders do not require any previous seller notes to be subordinated if there isn't a lien filed.

If there isn’t a seller note then how would a claw-back provision work?

Escrow agreements are typically utilized in 100% financed loans for the claw-back provision. The seller will typically receive most of the purchase price at closing wired from the lender. The portion set aside (like 20% to 25%) for the claw-back provision is wired into the escrow account. Some lenders will handle the escrow internally and others will require you to find your own escrow firm. In either case, there is an escrow agreement between the buyer, seller and escrow agent. The agreement spells out when the money will be distributed and the formula that will be used to calculate the distributions. If the retention provisions are met, then all of the proceeds will be delivered to the seller. If the claw-back provision is triggered, then the seller receives the adjusted amount and the balance is usually applied to the buyer’s loan balance.

Why aren’t sellers typically financing any portion of the purchase anymore?

Seller financing is still common and frequently used when the broker dealer is lending up to 50% of the acquisition to the buyer and the seller finances the rest in either a fixed note or earn out. Seller notes are also common when an advisor purchases clients from another advisor they know, and pays part from cash on hand and the seller finances the rest.

But when the deal is being financed by a conventional or SBA loan (especially SBA), there is no seller financing involved for the majority of deals we’re seeing.

Here are the key reasons why:

• In 2018, the SBA changed their acquisition equity injection rules. Before the change, the SBA used to require the seller to finance 25% of the purchase price. The new equity injection rule no longer requires (but allows) seller financing. Conventional lenders we work with who also used to insist on some level of seller financing component, have been doing most of their deals over the last few years without a seller note and utilizing an escrow agreement to satisfy retention/claw-back provisions.

• Most seller notes are structured from 3 to 5 year terms compared to the 10 year terms offered by conventional and SBA loans. Borrowers often prefer the additional cash flow generated from the longer amortization of the bank loan, over saving a percentage point or two from the seller note.

• In the competitive M&A landscape, where there are many buyers and few sellers in comparison, buyers utilizing external financing are able to utilize 100% financed loans as a competitive advantage in their offer. With all else equal, most sellers would rather accept the offer where they get most all of their money upfront and bear little risk other than the portion set aside for limited attrition protection. This is more attractive than a slightly larger offer but only half the money up front and the seller bears all the risk for the rest.

• Any seller promissory note has to be subordinated to the lender note regardless of the percentage of the purchase the seller finances. This is extra risk to the seller since they would not be able to collect in a default scenario until the bank is satisfied. The bank can also halt their borrower (the seller’s buyer) from making the seller note payments if cash flow gets tight causing the borrower to struggle to make the monthly bank payments.

• For acquisition loans today, the escrow agreement has replaced the seller note being required from the borrower for a retention/claw-back period. The escrow structure allows for the amount to be set aside and disbursed according to the time tables and claw-back formulas laid out in the agreement. The seller often prefers this since they know the money is in an account waiting for them.

What scenarios are seller promissory notes being utilized?

• The broker dealer is lending up to 50% of the acquisition to the buyer and the seller finances the rest in either a fixed note or earn out.

• When two advisors who know each other goes old school where a small percentage is paid in cash and the seller finances the rest with a promissory note.

• When an advisor uses a lender that just isn’t comfortable with 100% bank financing.

• When the buyer is W2, novice, or without production.

• Buyer whose practice has too low of a business value compared to the seller practice value being acquired.

• When the deal doesn’t cash flow strong enough, the LTV is too high, or the lender has other concerns about the deal.

• When the purchase price is higher than the valuation, the difference must be structured in a seller promissory note for SBA loans.

• The seller insists on having a seller note in place because they want to receive payments over many years.