ADVISOR LOANOLOGY

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.

If the buyer is getting a SBA loan, then the SBA has a 10% equity injection requirement. Most established independent advisor buyers satisfy this requirement without having to make a cash down payment but some don’t for a variety of reasons.

For the advisor buyers required to put a 10% cash down payment, the SBA allows for the seller to finance this with a standby seller 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 as a standard rule. If they do we suggest you just walk away. Most all lenders with experience in advisor lending will base it only on LTV and if the LTV qualifies. usually from 75% to 85% then the bank shouldn’t care if this partially or all comes from the value of the buyer’s business.

  • 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).

Fixed & Adjustable
Promissory Notes

Fixed and Adjustable Notes

Promissory notes are commonly used in advisor acquisitions, with two primary forms: fixed and adjustable. The main difference between these two types lies in their payment structures and the degree of protection they offer to the borrower.

Fixed Promissory Notes

In fixed promissory notes, the amount owed remains unchanged throughout the payment period, regardless of any changes in client or revenue attrition. The buyer makes fixed, predictable payments to the seller, typically with interest, over a set period, regardless of the performance or financial outcomes of the acquired business. This type of note offers stability to both parties but limits the potential for adjustment if the retention underperforms.

Adjustable Promissory Notes

Adjustable promissory notes are structured to provide some level of protection to the borrower in the event of unexpected attrition in clients or revenue. In these notes, the amount owed by the buyer is subject to adjustment based on predetermined benchmarks or clawback provisions. If the retention benchmark for clients or revenue isn't met, the buyer has the option to adjust the price and "claw back" a portion of the purchase price from the seller. With Small Business Administration (SBA) loans, the adjustment amount to the seller can only be decreased and cannot be increased.

Seller Note Subordination

Seller Note Subordination

The subordination of seller promissory notes to the lender is a critical requirement for most acquisition loans.

Subordination is based on The "Senior Debt" and the "Seller Note":

Senior Debt

Senior Debt: This is the main loan provided by the bank for the acquisition. When it comes to repayment and default scenario, the Senior Debt takes precedence. It essentially holds the strongest claim on your assets if a default occurs.

Seller Note

Seller Note: The Seller Note is a form of debt given out by the seller to you, the buyer. Rather than making an upfront full payment for the purchase, you agree to repay the seller in installments, with interest over a predetermined period.

Seller Note Subordination

Seller Note is "subordinate" to the Senior Debt, implying:

Repayment Order: In case of financial strains, the Senior Debt has to be settled in full before any payments can be directed towards the Seller Note.

Implications of Default: In the event of a default on the Senior Debt, the bank has the right to claim your assets to recoup the outstanding loan amount. However, regular servicing of the Senior Debt leaves the Seller Note untouched.

Security Interest: The bank may use your Seller Note as extra collateral for the Senior Debt, thereby enhancing their claim on your assets in case of a default.

Rule 2040 Applies to Advisors Selling Their Practice and Giving Up Their License

When a licensed financial advisor decides to sell their practice and retire, they need to navigate the regulatory landscape to ensure they receive their fair share of the sale proceeds. FINRA Rule 2040 provides a framework that allows for such a transition, ensuring compliance with federal securities laws while facilitating ongoing compensation for retired advisors, provided certain conditions are met.

Under Rule 2040, a retiring registered representative can continue to receive commissions from accounts held for continuing customers. This is permissible provided there is a bona fide contract established while the advisor was still registered, detailing the terms of the ongoing payments. The contract must explicitly forbid the retired advisor from soliciting new business, opening new accounts, or servicing existing accounts generating the ongoing commissions. This ensures that the retired advisor's activities remain in compliance with applicable federal securities laws and FINRA rules.

For the arrangement to be valid, the advisor must cease their association with the member and leave the securities industry. Still, the contract can stipulate provisions for continuing payments even in the event of the advisor's death, directing these payments to a designated beneficiary or the advisor’s estate.

https://www.finra.org/rules-guidance/rulebooks/finra-rules/2040

Utilizing Escrow Agreements in Acquisition Loans

Purpose of Escrow in Acquisitions

An escrow account acts as a secure holding account for a portion of the purchase price. It provides protection for both the buyer and the seller by ensuring that funds are available to fulfill specific obligations or contingencies outlined in the acquisition agreement.

Escrow agreements are typically utilized in 100% financed loans for a clawback provision. 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 when the loan is closed. Some lenders will handle the escrow internally and others will require the borrower to find their own escrow firm. In either case, there is an escrow agreement between the buyer and seller. 

The agreement spells out when the funds will be distributed and the 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 period the agreed upon attrition delta is triggered, then the seller receives the adjusted amount and the balance is “clawed back” and usually applied to the buyer’s loan balance. 

How Escrow is Used

Attrition Offset Clawbacks: One common use of escrow in acquisitions is to manage potential attrition offsets. It involves setting aside a portion of the purchase price in the escrow account for a specified period. If client attrition exceeds predetermined thresholds, the escrow funds are used to offset the financial impact.

Seller Payment Distribution: In some cases, escrow accounts are utilized when the seller wants to receive payments over the next 2-3 years instead of all at closing for tax purposes. For example a purchase can be closed in December with down payment funded to seller and balance going into escrow with payments disbursed from escrow to the seller on January 5th for the next 2 or 3 years.

Purchase Price Adjustments: Escrows can also be used to account for adjustments to the purchase price based on certain conditions or contingencies, such as the accuracy of financial representations, resolution of pending lawsuits, or the satisfaction of regulatory requirements. The escrow funds may be released or retained based on the outcome. 

Tax Deferral

Seller-financed deals present unique opportunities and challenges, particularly when it comes to tax matters. One critical aspect is the prevention of constructive receipt which can sabotage tax deferral advantages. To prevent constructive receipt in these agreements, sellers must relinquish any control or access to the sale's proceeds, even if these funds reside in an escrow account.

Key Considerations:

Escrow Beyond Basics: Merely placing the funds into an escrow account doesn't suffice. It's imperative that the seller is barred from exerting control over, or accessing, the escrowed funds.

Alternative to Escrow: While escrow services are common, an attorney-client trust account can also fulfill this role efficiently, potentially reducing both complexity and costs.

Unambiguous Agreements: The terms of the escrow account or any trust agreement should explicitly preclude the seller’s access to the funds. Vague terms can result in constructive receipt, thereby creating instant tax obligations.

Loan Risk and Sale Price: The presence of seller financing generally does not reduce the sale price of the asset. Instead, the risk factored into the loan is offset by the interest charged, distinguishing it clearly from the sale price.

Interest Rates and Risk: Setting a fair interest rate is essential, reflecting the risks the seller takes on. This separation between the purchase price and interest prevents confusion and reduces the likelihood of conflict between the involved parties.

Escrow Process

Establishing the Escrow Account: Typically, an escrow agreement is entered into among the buyer, seller, and an escrow agent (often a third-party entity or an agreed-upon financial institution). It outlines the terms and conditions of the escrow, including the funding amount, duration, and distribution provisions.

Funding the Escrow: The agreed-upon portion of the purchase price is transferred to the escrow account at closing from the lender financing the acquisition loan. This amount is held by the escrow agent until the conditions or contingencies specified in the acquisition agreement are met.

Distribution of Escrow Funds: The distribution of escrow funds occurs based on the provisions outlined in the escrow agreement. If the conditions are met, the funds are released in full or in part to the seller. If a clawback provision is triggered due to attrition or other reasons, the adjusted amount is paid to the seller, and any remaining balance is often applied to the buyer's loan balance or returned to the buyer. 

Constructive Receipt

The topic of constructive receipt is critical when navigating the intricacies of seller-financed transactions. It's essential to note that avoiding constructive receipt implies more than just depositing the funds into an escrow account. The primary step is clear-cut: the fund cannot simply be placed in escrow. The next vital action ensures that the seller has no access to these funds, maintaining the tax deferment stance. This is where an escrow agreement becomes instrumental; however, it's often a misconception that a formal escrow company must be employed.

Many deal structures utilize the attorney-client trust accounts of the seller or buyer to act as an escrow agent. This alternative not only expedites the process but also proves to be cost-effective. Most importantly, the instructions for this account must be unambiguous to ensure that sellers cannot access the funds; otherwise, constructive receipt occurs, incurring immediate tax liabilities. Therefore, while this approach mirrors traditional escrow in function, it's imperative that sellers understand that they must adhere to strict terms or face taxation consequences.

As for seller financing and its impact on the sale price, the crux lies in differentiating between the sale price and the interest charged. Although sellers carry a degree of risk when offering financing, the sale price typically remains unaffected regardless of who carries the 'paper.' Instead, compensation for this risk should manifest in the interest rate, although setting a rate that matches the true risk can often be challenging. Issues surrounding collection amplify this complexity. Nevertheless, it's crucial to remember that while risk can theoretically influence the overall purchase price, in practice, it should be encapsulated through interest rates, ensuring both parties understand and agree on the terms to mitigate potential disputes.

Earn-out Notes

An earn-out is a type of payment structure commonly used in financial advisor acquisitions. It involves the buyer making a partial payment upfront and the remaining amount being contingent upon the financial performance of the acquired business after the acquisition. Typically, a percentage of the revenue or net operating income (NOI) is agreed upon and paid to the seller over a specified period of time or until a predetermined amount is reached.

This payment structure is often preferred by sellers of high-growth businesses who believe that the value of their business exceeds what a traditional business valuation represents. Earn-outs are also more popular when the buyer is using cash for the down payment or when a bank loan is involved in the acquisition. In the latter case, the buyer obtains a loan for a portion of the purchase price, usually 50% to 75%, and the remaining amount is paid to the seller based on the future performance of the acquired business.

  • Earn-outs involving conventional and SBA loans

    Conventional loan - As long as the projected earn out terms cash flows, most conventional lenders accept earn-out structures. From a lender’s perspective, earn-outs provide some short-term  protection for their borrower from a significant downside turn in revenues after the loan closing. And, as with a seller promissory note or escrow agreement provision, earn-outs provide some protection for higher than anticipated attrition. Also similar to seller financing, earn-outs provide the lender with a low LTV, while still being in first lien position with the earn-out subordinated to the lender.

    SBA loan - The SBA prohibits earn-out structures. Earn-out promissory note structures are not allowed in SBA lending. If it looks like, or smells like a “revenue share” arrangement, the SBA lender won’t approve the purchase agreement. If a seller is set on having an earn-out structure and the buyer needs a bank loan for the down payment, they will need to qualify for a conventional loan.

  • Earn-out Note Subordination

    In most cases, the earn-out note is required to be subordinated to the lender if a bank is involved in the transaction. This means that the seller's right to receive earn-out payments would be secondary to the lender's rights and repayment priority. The subordination ensures that the lender has first claim to the borrower's assets and cash flows, including any earn-out payments, in the event of default or financial challenges. This is similar to how a seller promissory note would also be subordinated to the lender's interests.

  • More complicated legal and tax considerations 

    Earn-outs generally have more complex legal structures compared to other payment arrangements. They involve detailed terms and conditions that are contingent upon future performance and can include various provisions, such as revenue targets, financial milestones, or clawback provisions for revenue attrition. The complexity arises from the need to define and agree upon specific metrics, timelines, and conditions for determining the earn-out payments. Additionally, legal documentation is required to outline the terms of the earn-out, including the calculation method and the rights and responsibilities of both the buyer and the seller.

  • When seller is retiring during the earn-out term

    If a licensed financial advisor seller retires during the earn-out period, it is important to address this situation in the purchase agreement. The retiree's retirement may impact the terms and conditions of the earn-out structure. The lender's lawyer reviewing the deal would typically want to ensure that the retirement is accounted for in the language of the purchase agreement.

    Depending on the advisor's model and affiliation, different rules and regulations may apply to a buyer paying part of the practice's revenue to an unlicensed individual, such as a retired seller. Custodians usually allow for this by qualifying the seller as a "solicitor," enabling ongoing payments even when the seller is not licensed. However, it is crucial to consult with the Independent Broker Dealer (IBD) and custodian early in the process to determine and account for any earn-out requirements in the event of the seller's retirement.

  • When seller is continuing to work throughout the earn-out term

    If the seller of a financial advisor business is staying licensed throughout the earn-out period, there are generally fewer complications compared to when the seller retires. In this scenario, there would be no issue with the seller continuing to receive earn-out payments directly.

    While most Independent Broker Dealers (IBDs) permit such direct payments, it's important to note that there might be certain IBDs that have specific rules and compliance requirements. Some IBDs may insist on establishing a team ID rep code, whereby a portion of the compensation is paid to the buyer's rep code and the remaining portion to the seller's rep code.

  • Buyer pre-qualification even more important with earn-outs

    Borrower pre-qualification becomes even more important when the seller wants both a big down payment and an earn-out structure. In such cases, the buyer needs to be strong enough to qualify for a conventional loan to finance the down payment portion. If the buyer does not meet the criteria for a conventional loan, they may not be able to obtain financing for the down payment and, consequently, the entire deal may fall apart.

    By going through the pre-qualification process for an acquisition loan beforehand, the buyer can determine the loan amount they can target and assess the deal structures that are feasible for them. This helps avoid situations where the buyer and seller agree on terms, sign agreements, and set an acquisition date before realizing that the buyer does not qualify for the necessary financing.

  • Earn-out workarounds

    When using an SBA loan, earn-out structures are generally not allowed. However, there are workarounds that can be utilized to achieve a similar outcome. Instead of relying on an earn-out structure, advisors can explore alternative options to get the deal done. Here are a few possible workarounds when using an SBA loan:

    1. Seller Promissory Notes: The seller can provide a promissory note, where the payment is structured over multiple years and can be adjusted based on revenue attrition. This allows the seller to receive payments over time, contingent upon the performance of the business.

    2. Escrow Agreements: Similar to seller promissory notes, an escrow agreement can be structured to distribute payments to the seller over a period of time. Clawback provisions can be included to account for any revenue attrition.

    3. Premium Price with Seller Note: The buyer and seller can agree on a premium price, where the difference between the business valuation and the purchase price is covered through a seller note. The seller can then receive a fixed dollar amount over time, adjusted based on predetermined benchmarks.