Promissory notes are used as funding mechanisms in many buy-sell agreements. Yet the potential notes to be issued when trigger events occur are often given little thought by drafting attorneys or parties to buy-sell agreements. They should because the terms of these promissory notes matter both to issuing companies and to receiving shareholders who sell their shares.
A number of years ago, I wrote a generalized Checklist for Shareholder Promissory Notes in Buy-Sell Agreements (available at link). This more specific post deals with only three terms – the interest rate, the term (length) of notes, and the principal repayment terms.
Structure and Terms Matter
The structure and terms of the funding arrangement developed in connection with buy-sell agreement transactions matter. Companies (and remaining shareholders) have different interests regarding the funding of buy-sell agreements than sellers.
Assume for purposes of discussion that the purchase price for an interest following a buy-sell agreement appraisal process is $10.0 million. It matters, both to the company (and remaining shareholders) and the selling shareholder, how that purchase price is to be paid. Let’s look at a few common possibilities for funding the purchase price in an example. The example below illustrates that details can dramatically change the situation and, thus, should be agreed upon before a trigger event occurs.
Cash at Closing
One basic structure is, of course, the payment of cash in full at closing. That solution is simple for selling shareholders, but it may be difficult for a company. Nevertheless, the option would look as follows.
100% Cash Payout at Closing $10,000,000
The seller is paid in full and the company has either reduced its available cash by the $10.0 million amount, increased its external debt, or a combination of the two options (assuming no new stock issuance). Any external financing required to make this payment is a matter of concern only to the company. The selling shareholder is paid in full and has no future risk associated with the company, either as an equity owner or as a debt holder.
Level Payment for a Term of Years (Vary the Interest Rate)
One note structure that is commonly used in buy-sell agreements is the issuance of a term note at an agreed upon interest rate for an agreed upon term of years (or quarters). This structure calls for a level payment each year, which is comprised of principal and interest. As with a typical home mortgage, interest payments are relatively heavy in the early years and principal reductions are relatively light. As the principal is reduced over time, the interest component is lowered and the principal reduction increases.
Some sellers may prefer this structure because the capital gains taxes on receipt of principal are deferred somewhat. The idea of a level payment is also attractive to some sellers.
The examples all assume that there is a 20% down payment ($2.0 million in this example). Since the purchase price is $10.0 million, the remaining note balance is $8.0 million.
In the figure below, the $8.0 million promissory note balance is to be paid in equal annual payments for a term of ten years. In the figure, the note interest rate is varied from 2.0% to 8.0%. The implied annual (or quarterly) payments are calculated, and the range of payments is then shown for the range of interest rates. What is clear is that the interest rate on promissory notes matters. This may seem obvious, but it is best to spell it out so you and your clients can discuss the relative merits of different structures.
Sellers might prefer regular quarterly payments, while companies might prefer annual payments to provide maximum flexibility in meeting required payments. What is clear is that the selected interest rate matters. The annual payment for a ten year term at a 2% interest rate is $891 thousand. The payment with an 8% interest rate is $1.19 million, or 34% (that’s $301 thousand) higher.
In the next figure, we hold the interest rate steady at 6% and vary the term of the note from four years to ten years. We then calculate the annual and quarterly payments that are implied by each structure.
Sellers might prefer a shorter term to minimize their risk exposure to a company. On the other hand, companies typically desire longer terms to minimize their cash flow requirements for debt service. With a four year term, the annual payment is $2.31 million. With a ten year term, the debt service is only $1.09 million per year (that’s $1.22 million lower with a longer term). What is clear from the second example is that the term on promissory notes matters to the parties, as well.
Level Payment of Principal
Another structure that appears in some buy-sell agreements calls for a level amortization of principal over the term of the note. In our example with an $8.0 million note and a ten year term, we can look at the cash outflows (from a company’s viewpoint) and inflows (from a selling owner’s perspective) under an assumed interest rate of 6%. The note is illustrated in the following figure.
In this example, principal is reduced at the rate of $800 thousand per year. Interest accrues at 6% on the beginning principal each year and is paid at each note anniversary date (assuming annual amortization). The first year payment is $1.28 million, and the payment is reduced each year as the principal is reduced with each year’s payment. The last payment is $848 thousand.
The payment stream above can be compared with the 6%, ten year, level pay assumptions above, which call for an equal annual payment of $1.09 million.
The example above is with a fixed rate of 6%. The parties could agree on a variable rate for the note. If they did so, they would need to specify the market base rate that would set the rate and add to it any agreed upon premium. A variable rate note could call for annual resetting of the interest rate or for a resetting after some period of years.
Conclusion and Wrap-up
The terms and structures we have discussed thus far are fairly common commercial terms. For purposes of buy-sell agreements, it is important to clearly specify the economics of promissory notes such that they can be implemented without controversy upon a trigger event and transaction.
In the next post, we will address another important question regarding promissory notes issued in connection with buy-sell agreements: What is the Fair Market Value of the Promissory Note?
What we will see is that fair market value might not be fair market value at all!
New Book on Buy-Sell Agreements
The drafting of a new book on buy-sell agreements is almost complete. The working title is Buy-Sell Agreement Handbook for Attorneys. I am not an attorney. As always, I write based on my experience as a businessman and valuation guy.
My previous books on buy-sell agreements have been written from the perspective of business owners as in the title of the most recent book: Buy-Sell Agreements for Closely Held and Family Business Owners. Attorneys were, thankfully, one of the bigger markets for this book.
Many times, however, attorneys have said to me, in effect, “Chris, we like the ideas in your book. Do you have some template language to help us implement them?”
Until now, unfortunately, the answer was a “Not yet.” Now, this new book will contain detailed template language for several valuation processes for buy-sell agreements. I’m excited to get it to the point of making it available to attorneys, business appraisers, financial planners and, yes, business owners.
If you want to be notified when Buy-Sell Agreement Handbook for Attorneys becomes available, give me a quick email and we will put you on the list at firstname.lastname@example.org.
In the meantime, be well!