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What is a seller-financed purchase price actually worth in cash?

A price paid partly in seller notes is two numbers: what the seller holds and what the buyer carries. Priced from both sides, the notes are part of the price, and they are what takes year 1 below one.

Julian R. Sterling · from Buying a Small Business

Cedar Ridge Mechanical sells for 2,600,000, of which 405,416 is paid in two seller notes. Discount those notes at 10 and 15 per cent, the rates the companion case adds, and the price is worth 2,533,642 in cash today: 66,358, or 2.55 per cent, below the headline. Paid that value in cash at closing, the buyer's cheque nearly doubles, from 162,897 to 313,759, and first-year cash coverage rises from 0.96 to 1.04. The notes save the buyer cash and cost him coverage.

The companion workbook for Deal A prints the seller's cash at closing, 2,194,584, and moves on. Neither side's view of the notes is taken to a number: what the 2,600,000 is worth to the seller, and what the notes actually buy the buyer. Case three in the companion files does both. The figures below are the workbook's; the workbook itself is in thousands of dollars, so 2,533.6 there is 2,533,642 here.

The two notes, as the deal is structured

The book finances Cedar Ridge with an SBA 7(a) loan of 2,340,000 at 10 per cent over ten years and two seller notes. The first is a paying note of 10 per cent of the price, 260,000, amortising monthly over five years at 7 per cent. The second is a standby note of 5 per cent of total uses, 145,416, on full standby: it pays nothing while the SBA loan is outstanding, accrues at 6 per cent, and counts towards the buyer's 10 per cent equity injection. In the book's case it is repaid at the exit at the end of year 5, with its interest, as 194,599.

Two discount rates are needed to value them, and the book gives neither. The case adds them, marked as its own assumptions: 10 per cent on the paying note, which is subordinated to the SBA loan but pays from the first month, and 15 per cent on the standby note, which is subordinated, unpaid and repaid only if the SBA loan is.

Case three, sheet “1. The seller notes”, rows 52 to 59. The two discount rates are added by the case; everything else is workbook A as shipped.

What the seller receives	Face or amount	Value today	Discount
Cash at closing (price less both notes)	2,194,584	2,194,584	0
Paying note, 260,000 at 7 per cent over five years, valued at 10 per cent	260,000	242,307	17,693
Standby note, repaid as 194,599 at year 5, valued at 15 per cent	145,416	96,750	48,666
The price	2,600,000	2,533,642	66,358

The standby note is 35.9 per cent of the notes' face and 73.3 per cent of the discount. A seller who reads the paying note as a small concession and the standby note as a formality has the two the wrong way round: the paying note costs him 17,693 of value, the standby note 48,666.

The standby discount is also the one that moves. If the note has to wait for the end of the SBA term instead of the book's exit, it repays 260,417 at year 10, and the price is worth 2,501,263 to the seller: a discount of 98,737, half as much again. Nothing in the note decides which of those two repayment dates applies. The SBA loan and the buyer's exit do.

The same value, paid in cash

The obvious comparison is the wrong one. Removing the notes and keeping the price at 2,600,000 hands the seller 66,358 more than the structured deal is worth to him. The fair comparison pays the seller exactly what the notes give him, 2,533,642, all at closing, and asks what the buyer then needs.

Case three, rows 83 to 89. Year-1 taxable income is a loss in both structures, −396,370 and −385,821, so neither pays tax.

Year 1 for the buyer	With the notes	All cash at 2,533,642	Difference
Buyer's cash at closing	162,897	313,759	150,862
SBA loan, personally guaranteed	2,340,000	2,533,642	193,642
SBA guaranty fee (financed)	63,313	68,759	5,446
Debt service, year 1	432,859	401,787	−31,072
Lender's coverage (adjusted EBITDA of 676,000 over service)	1.56	1.68	+0.121
Cash coverage, year 1 (after 260,000 of capex; no tax)	0.96	1.04	+0.074

Two things happen at once. The buyer's cheque nearly doubles, because under the whole-loan reading of the SBA valuation cap the loan cannot exceed the price. Uncapped, the all-cash loan would size itself at 2,563,414; capped, it stops at 2,533,642, and the buyer funds the 150,000 operating cushion, the 95,000 of closing costs and the 68,759 guaranty fee himself. That is 313,759, against the 284,740 that 10 per cent of the uses would have required. With the notes, the same cap already costs the buyer 17,481 above the required injection; without them it costs 29,019.

And the year that fails stops failing. The book's structure covers its debt 0.96 times in year 1 once capex is paid, which leaves the buyer 16,859 short. Paid in cash at the seller's own value, the same business covers 1.04.

Why the cheaper debt costs more coverage

The paying note carries 7 per cent against the SBA loan's 10. It is still the more expensive debt to service, because it amortises over five years against ten. Its 61,780 a year is 23.8 per cent of its face; the SBA loan's 371,079 is 15.9 per cent of its 2,340,000. Replacing 405,416 of notes with 193,642 more SBA debt, 150,862 more cash and a price 66,358 lower cuts year-1 service by 31,072, and 31,072 is the difference between 0.96 and 1.04.

The seller notes are what take the book's structure below one. Not the price, and not the SBA loan: the paying note's 61,780 a year. A seller offering to “carry paper” is offering a lower rate on a shorter term, and the term is what the first year feels.

Does the answer depend on the discount rates?

The seller's value does. The buyer's side barely does, and that is the more useful finding. Under the whole-loan cap the all-cash buyer's cheque is the cushion, the closing costs and the guaranty fee, and only the fee moves with the price, at 2.8 cents on each dollar of it.

Case three recalculated with only cells C29 and C30 changed; the structure with notes covers 0.96 in every row.

Seller's discount rates (paying / standby)	Price worth to the seller	Discount on 2,600,000	All-cash buyer's cheque	All-cash coverage, year 1
7 / 6 per cent (the notes' own rates)	2,600,000	0	315,625	1.01
10 / 10 per cent	2,557,722	42,278	314,436	1.03
10 / 15 per cent (the case)	2,533,642	66,358	313,759	1.04
10 / 20 per cent	2,515,096	84,904	313,237	1.04

The first row is the limiting case. Discounted at their own coupon rates the notes are worth exactly their face, the price is worth exactly 2,600,000, and the case's checks sheet tests that identity. Even then, paying the full 2,600,000 in cash covers year 1 at 1.01 where the book's structure covers 0.96. Whatever the seller thinks his notes are worth, removing them lifts the first year above one; what the rates decide is how much the seller gives up for the notes, from nothing to 84,904 across this range.

What the notes buy, and at what price

Put in one line: the notes save the buyer 150,862 of cash at closing and 193,642 of SBA debt under his personal guarantee. They cost the seller 66,358 of value and the buyer 0.07 of year-1 cash coverage. Each dollar of value the seller gives up saves the buyer 2.27 dollars of cash at closing.

For a buyer short of cash, that is cheap. It is not free, and the parts of it land on different people. The seller is lending behind the SBA, at a lower rate than the SBA charges, and on the standby note receiving nothing for as long as the loan is outstanding. The buyer is taking a first year that does not cover its debt in exchange for a smaller cheque and a smaller guarantee.

• Value the notes as the seller must. A headline of 2,600,000 with 405,416 of notes is a smaller number in cash, and most of the gap is in the note that pays nothing.
• Set the paying note's term beside its rate. A five-year note at 7 per cent costs more first-year coverage per dollar than a ten-year SBA loan at 10.
• Rebuild the deal at the seller's cash value with no notes, not at the headline price. That comparison, and not the headline, says what the notes are doing.
• Negotiate the notes and the price as one number. A longer paying note, or a slightly lower price in exchange for more paper, can be worth more to both sides than an argument about either alone.

Reproducing it in the workbook

Everything above is in Three_Cases.zip, file Case_3_The_Seller_Notes_Priced.xlsx, sheet “1. The seller notes”. Section A (rows 33 to 49) rebuilds workbook A's sources and uses and reproduces Cedar_Ridge_Acquisition_Model.xlsx to the cent: the loan of 2,340.0 in C43, the fee of 63.3125 in C44, the buyer's cash of 162.896875 in C47. Rows 52 to 61 value what the seller receives, with the total in C57 and the discount in C58. Section B (rows 63 to 79) finances the seller's value in cash, section C (rows 81 to 89) sets year 1 side by side, and section D (rows 91 to 95) states the trade.

The two discount rates are in C29 and C30 and the alternative repayment year in C31; the note sizes and rates are in C8, C9, C13 and C15. Change them and sections C and D recompute. Sheet “2. Checks” ties section A back to workbook A and closes on ALL OK. In workbook A itself the same year-1 figures sit on Sources_Uses (B16 to B31) and Operations (B22 to B25).

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