Best Practices: Seller Notes in Business Acquisitions

Under the Change of Ownership section of SOP 50 10 5(I), when the purchase price of a business includes intangible assets in excess of $500,000.00, the borrower and/or seller must provide an equity injection of 25% or more of the purchase price for the application to be processed under delegated authority.  If seller is contributing to this required equity injection by providing seller financing, seller may not receive any payments under such financing for a period of at least 2 years from the closing date (the “Standby Period.”)

Before closing, a lender should obtain a copy of the draft seller note for review.  Things that a lender should look for when reviewing the seller note are as follows:

• Is the debtor/payor on the seller note the borrower?  If not, the note should be revised to reflect the borrower as the debtor.
• Who is the payee on the seller note?  It should be the seller or the principals of the seller.  If it is not, then further information is needed as to why the parties listed are to be paid, even though not a party to the transaction, or the payee should be revised to be seller or its principals.
• Is the Standby Period discussed in the repayment terms of the note?  If not, the note should be revised to clearly state the Standby Period starting from the closing date.  This is especially important if the seller note is to be signed in advance of closing because the Standby Period must be from the date of closing, not the date of the note.
• Do the terms match the underwriting terms?  If not, the note must be revised to match.
• Is prepayment of the note allowed?  If so, does the note state that prepayment is not allowed during the Standby Period?  If not, the note should be revised accordingly, as there should be no payment of any kind permitted during the Standby Period.
• Are there any provisions in the note that would allow the seller to obtain more money than the debt amount (i.e. an earn out provision if borrower sells the business while it still owes money on the note)?  If so, these provisions should be removed from the note as seller should not receive any profit earned by the business after the sale has occurred.
• Is there any language in the note identifying that it is subordinated to the lender’s loan?  If not, lender may want to request that such language be added, so if the note is ever assigned by seller to a third party, that third party is aware of the subordination of the note to lender’s loan.
• Is the note secured by any collateral?  If so, lender should obtain copies of the documents that will be executed by borrower/borrower’s principal(s) granting such collateral for review.  If lender is taking a lien on the same collateral for its loan as well, lender may want to require that language be added to such seller collateral documents indicating that seller’s lien is subordinate to lender’s lien in such collateral.

In addition to reviewing the seller note prior to closing, lender needs to have the seller/payee execute a standby/subordination agreement and attach a copy of the executed seller note to same.  The U.S. Small Business Administration (“SBA”) has a form of Standby Creditor’s Agreement that can be used in this situation, but lenders are not required to use this form.  A lender can modify the SBA’s form or can use its own agreement.

With the special attention that SBA has placed on lenders to obtain documentation proving that a borrower injection requirement has been met, reviewing seller financing documents for compliance with standby requirements is extremely important. For more information on seller note considerations, contact Janet at 267.470.1189 or at jdery@starfieldsmith.com