The most common questions we get from sellers centers around seller financing and escrow based payment structures. They want to know how the loan their buyer is getting will impact how and when they get paid.

If you are curious about avoiding seller financing or how an escrow agreement can circumvent a seller promissory note see our article: 100% Bank Financed Acquisition Loans is The Norm.

Fixed seller financing is different than an earn-out. An earn-out structure is where the buyer usually pays a portion of the purchase price as down payment and the rest is paid out contingent on financial performance, post acquisition. For more information on earn-out structures when a bank loan is involved visit our FAQ - Acquisition Deal Structures and see our article: Advisor Acquisition Loans and Earn-out Structures.

If a seller will be self-financing part of the purchase price they want to know the options, how it works, and what the drawbacks are. This article covers these topics and written for the seller’s perspective, specifically for the wealth management industry, and in the context of when seller financing is in combination with bank financed loans.

What is seller financing?

Seller financing is when a seller provides a loan to the buyer to cover part of the purchase price. In wealth management M&A, most acquisitions are paid for from the buyer getting a conventional bank loan, a SBA bank loan, or a loan from their firm or broker dealer. When seller financing is involved, the buyer is obtaining two loans, one from the external lender and one from the seller.

If there is seller financing involved, then a promissory note between the buyer and seller is drawn up as part of the purchase agreement.  The buyer agrees to pay a specific amount per month or quarter for a specified period of years. Interest rates applied are usually in the 5% range. 

Lenders do not want to see too much pressure on cash flow from a seller note, especially in the early years. While each deal is unique, lenders generally prefer the payment terms to be from 5 to 10 years. Most sellers prefer a seller note that goes for 2 to 5 years. If the portion being financed is small enough that it isn’t too much of a drag on cash flow, this can be done. However, AdvisorLoans and our lenders will advise a borrower not to have too much, for too short of a time period, in seller financing. The bank loan portion is paid out on a 10 year amortization term which provides cash flow benefits for the borrower over short-term seller notes.

Adjustable Promissory Note Structured For Claw-back

In wealth management M&A the two primary forms of seller financing is fixed and adjustable. When a bank loan is involved, most seller notes will have an adjustment to the amount owed based upon client or revenue retention.  

An adjustable seller note is designed to protect the borrower (somewhat) if client or revenue attrition is higher than expected. In general, banks prefer to see a provision that allows for the buyer to adjust the price and “claw back” a portion of the purchase price if a client/revenue retention benchmark is not met.

Usually the clawback adjustment period happens after the first year but we also see 18 months, as well as one claw-back price adjustment at one year and another after year two. The requirement of a clawback and any adjustment periods are primarily dependent on the perceived risk of client attrition of the acquisition. Clawbacks are just potential pricing readjustments based upon higher than expected client attrition, however with SBA loans the adjustment amount to the seller can’t go up, only down.

Some lenders will be more relaxed about clawbacks for internal acquisitions and succession acquisitions; in case of a “fire sale” based on the seller’s death or disability; or if an appropriate discount to the purchase price has been made to accommodate for a lack of a clawback adjustment provision.

The bank may also want a stronger clawback adjustment on an external acquisition (where clients need to be re-papered) than an internal acquisition. Banks will often request added clawback provisions that may extend for a longer period of time for attrition of specific clients if there is heavy concentration with a few clients, or a substantially large percentage of the revenue is from a few clients, that if not retained, would have a severe impact on cash flow.

Seller Promissory Note Subordination

In virtually all cases, banks require that the seller note be subordinated to the bank. This means the seller is in second position behind the lender. It doesn’t matter if the seller is financing 5% or 95%, the subordination is required. Lenders create their own subordination letters that the seller must execute in order for the buyer to close and fund the loan.

In addition, the subordination letter may also give the bank the right to pause the buyer from making seller note payments if the buyer is struggling to make the bank note payments.

Is seller financing required?

Most all acquisition deals less than $5 million can be funded without seller financing if that was the only consideration taken into account. A bank will always prefer that the seller finances a portion of the purchase, but what a bank “prefers” and will “allow” are different things. For the vast majority of the acquisition loans we do for loans under $5 million, the seller doesn’t 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.

The primary scenarios where a bank would require a portion of the purchase to be in seller financing are:

• If the buyer is getting a conventional loan then some lenders may require 10% to 25% of the purchase price to be in seller financing.

• 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, 10%-25% seller note is the typical percentage the lender would require.

• For SBA acquisition loans, if the valuation that the lender orders is lower than the agreed upon purchase price, and the buyer is still willing to pay the purchase price, the difference either needs to be paid in cash from the borrower (unlikely) or the seller can finance the difference with a seller note (typical).

If the buyer is getting a SBA loan, then the SBA has a 10% equity injection requirement. Most advisor buyers satisfy this requirement without having to make a cash down payment but some don’t for a variety of reasons. For the minority of advisor buyers that would be required to put a 10% cash down payment, the SBA allows for the seller to finance 5% of the purchase which would reduce the cash down payment from the buyer to only 5%. The SBA does not require 5% seller financing but allows for it. However, this specific 5% seller note would have to be on standby for the life of the loan. See details below.

Seller financing 5% of the SBA loan 10% equity injection rule

Most of our advisor clients that choose a SBA acquisition loan satisfy the SBA’s equity injection requirement without having to come out of pocket for a cash down payment. However, in the cases where the buyer is currently a W-2 employee, isn’t a 1099 advisor for a year, or doesn’t have GDC or revenue high enough in comparison to what is being purchased, the equity injection can be problematic.

For these cases, and when the combined practice values of buyer and seller do not meet the SBA equity injection requirement for “assets other than cash”, a 10% equity injection must be made. This can be satisfied by either a 10% cash down payment from the borrower, or if the seller is willing, a 5% borrower cash down payment and a 5% seller promissory note that is on full standby for the term of the SBA loan (10 years). The standby promissory note can accrue interest, but no payment (principal or interest) can be made for this note while the SBA loan is still active.

SBA Seller Notes (other than the 5% equity injection financing) 

The SBA only requires a standby term for the life of the loan for the 5% seller note used as part of the 10% equity injection requirement. The SBA allows for any other seller financing to be offered to the borrower without the standby requirement.

For example, if the equity injection is met without the need for a seller note then a seller note can still be issued to assist the buyer with cash flow and debt service, or for the seller to spread out some of the purchase price over years instead of receiving all in the same year (this can also be accomplished with an escrow agreement).

Any additional seller note would not be subject to the standby rule. For example, a seller can have the 5% equity injection seller note on the 10 year standby but have another 10% seller note that is paid every month over 7 years.

Sometimes when an SBA lender is concerned with short-term cash flow they may require that the seller note be on standby for 2 years before the buyer begins payments. Since the SBA rule changes that were made in 2018, this isn’t common, but we have seen it a handful of times over the last few years.

Using An Escrow Agreement As An Alternative To Seller Financing

Escrow agreements are typically utilized in 100% bank financed loans to account for clawback provisions. The seller will typically receive most of the purchase price at closing wired from the lender. The portion set aside (usually from 20% to 50%) for the clawback provision, is wired into the escrow account. Some lenders will handle the escrow internally and others will require the borrower to use a third party 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 clawback formula that will be used to calculate the distribution(s). If the retention provisions are met, then all of the proceeds will be delivered to the seller. However, if after the look back adjustment period, if the agreed upon attrition delta is triggered, then the seller receives the adjusted amount and the balance is “clawed back” by the buyer. The amount clawed back is usually applied to the buyer’s loan balance. 

Why seller financing has diminished in frequency

While seller financing is still prevalent in wealth management M&A it has rapidly diminished as a part of acquisition payment structures when bank financing is involved and the loan is not more than $5 million. Most SBA loans we have completed over the last few years have not had a seller financing component. Since 2018 there are also more conventional lenders willing to forego or reduce the seller financing requirement.

Most sellers are happy to shift the majority of the risk to the borrower and lender instead of hoping they don’t have to someday try to enforce a seller note that the buyer has stopped paying on. Here are the primary reasons we see contributing to the diminished state of seller financing:

• 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.

• Most sellers want to structure the notes from 2 to 5 years 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.

• 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 all or most all of their money upfront and bear little risk other than any portion set aside in escrow for attrition protection. This is often viewed as more attractive than a slightly larger offer but only half the money up front and the seller bears all the risk in a seller note or earn-out for the rest.

• Seller promissory notes have 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 (however unlikely) until the bank is satisfied. The seller subordination letter can also give the bank the ability to 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 most acquisition loans we see today, the escrow agreement has replaced the seller note being required from the borrower for an attrition/retention clawback period. The escrow structure allows for the amount to be set aside and disbursed according to the time tables and clawback formulas laid out in the agreement. The seller often prefers this structure since they know the money is sitting in an account waiting for them.

• The primary reason a seller may want to have part of the purchase in a seller note is to defer capital gains over a period of years. However, this can also be accomplished through an escrow agreement, so seller financing is not required to achieve this objective.

Call us to discuss seller financing and escrow agreement based disbursements for your specific situation and scenario.