“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” -Warren Buffet
Growth through acquisitions is a common occurrence for business owners. But judging whether the company to be acquired will meet Mr. Buffet’s definition of wonderful can be difficult. When circumstances are somewhat uncertain, some of the risk of the future performance of the acquired company can be shifted to the seller. A portion of the purchase price can be paid by issuing debt to the seller, and those notes can have special attributes, such as:
*“Earn out” provisions which can reduce the final loan amount if the acquired business fails to achieve predefined hurdles in sales or profits.
*“Standby” provisions that permit the buyer to cease making payments of interest or principal for a specified time if certain conditions are met (the loss of a major customer, for instance).
*“Waterfall” provisions that require the note to be paid more quickly if the acquired business cash flow exceeds a specified threshold.
Seller debt can also be helpful if the acquisition is being financed by an institutional lender. It will generally be counted as part of the lender’s required equity injection for the transaction if the debt is on full standby (no payments of interest or principal) until the lender’s note is paid in full.
Perhaps most importantly, buyers can likely gain confidence in the seller’s assertions about the target company when the seller will have a continuing interest post sale.