How the Seller Can Protect its Own Money
By Erwin G. Krasnow and John M. Pelkey, Garvey Schubert Barer for RBR.com
Not all buyers will be able or willing to rely on bank financing to fund the acquisition of a media property. In such cases, the seller may find that it has no choice but to allow the buyer to pay some portion of the purchase price on a deferred basis. “Seller paper” is always a risky proposition. The buyer may not do a good job of operating the media property. The fair market value of the property may decrease due to general economic conditions. The market in which the property is located may suffer a significant blow to its economy due to base or factory closures.
Any of these factors may lead to a situation in which the buyer comes knocking on the seller’s door on the day on which the deferred purchase price payment is due and ask for some accommodation, such as a reduction in the amount of the payment or an extension of the payment due date. Any such accommodation will be likely to mean a decrease in the actual dollars flowing to the seller.
There is no ironclad mechanism to prevent a post-closing renegotiation of the terms of the deferred payment. There are, however, six actions that a seller can take to decrease the likelihood that the buyer will show up on its doorstep on the payment date and to compensate the seller for undertaking the additional risk that comes into play whenever a seller agrees to provide the buyer with “seller paper”.
(1) Do some due diligence on the buyer. The best way for a seller to reduce risk is to select a well capitalized buyer with a proven record of success in operating similar properties. An essential first step for the seller is to conduct due diligence concerning the financial qualifications of the buyer, including the buyer’s background, credit record, management experience, ownership of similar properties, personal assets and character. Sellers should not hesitate to interview buyers who ask the seller to “take back paper” as they would when hiring an employee.
If a seller has any doubts about a buyer’s ability to operate the property and to pay the note, third party input should be solicited – such as other sellers who have closed deals with the prospective buyer. Also, subject, of course, to any confidentiality agreement between the seller and the buyer, the seller might find it helpful to talk with the buyer’s previous employers and employees. An experienced broker will assist in qualifying potential buyers by making sure they have sufficient funds and management capability to make a down payment, to operate the property, and to retire debt to pay the purchase price.
By providing financing, a seller is betting on the buyer’s ability to contribute its operating skills both to generate the cash flow needed to service the debt and to maintain sufficient value in the station to have the incentive to continue to make payments on the note. For example, the seller may be an absentee owner physically removed from the local market. The buyer may be a local resident who knows the market backwards and forwards. These local relationships may be uniquely valuable, and unavailable to the seller.
Advice to sellers: if you are not confident the buyer can operate the station successfully, do not offer financing.
(2) Make sure that the deferred payment is not a disproportionate portion of the purchase price. To minimize the risk of an installment sale, the buyer should be asked to make a significant down payment at the closing. It is usually in the seller’s best interest to finance no more than one-third to one-half of the purchase price. In the current climate of limited capital, however, the seller may need to be flexible – where it is prudent. A buyer with a sizeable down payment at risk has a powerful incentive to pay off the balance on a note for fear of losing the original down payment.
(3) Set the purchase price so that it reflects the risks of an installment sale – consider including a sweetener if the buyer pays early. Because the seller is incurring a potentially significant risk in agreeing to accept a portion of the purchase price on a deferred basis, a premium should added to the purchase price for an installment sale as compared to an all cash deal. This premium can be reflected in the purchase price or in the terms of the seller financing, such as the interest rate — or both, in situations where the seller has leverage.
The interest rate negotiated between the buyer and the seller will be a function of market factors, competition and perceived risk. With bank financing virtually non-existent, the seller may be justified in commanding a premium over a “market” bank rate. But the buyer will take into consideration the “value” of seller financing in proposing the purchase price. The rate is a delicate balance between the needs of the buyer and the seller. Another factor to keep in mind is that sellers generally pay capital gains taxes on the purchase price and taxes at ordinary income rates on the interest.
Most buyers seek seller financing because they must — not because they prefer it. The buyer simply does not have sufficient funds to buy the property using buyer’s own funds and a bank loan. Sometimes, this situation is of a temporary nature that the buyer is hoping will go away once the financing market improves. The seller may want to take advantage of the buyer’s expectations in this regard by offering a discount if the deferred payment is paid back early. Such an early payment discount can act as an additional inducement for the buyer not only to pay back the seller loan, but to pay the loan back early.
(4) Use a promissory note to reduce to writing the terms of the deferred payment obligation. A promissory note is a written promise to repay a loan or debt under specific terms (usually at a stated time, through a specified series of payments, or “on demand”). Notes typically contain provisions setting forth grace periods, late charges, default interest rates and attorneys’ fees. With respect to late charges, as with interest rates, there may be limits imposed by state law on fees that the seller can charge in the event of a late payment.
Here are some pointers the seller should keep in mind when negotiating the terms of a promissory note:
a) include an acceleration clause which will make the entire amount of the note due if a default is not cured within a specified grace period, whether that default is failing to make a payment when due or a breach by the buyer of any of the covenants or protective provisions of the note, security agreement or purchase agreement.
b) include a provision whereby the buyer acknowledges and waives its rights to notice of default, demand and notice of acceleration. The note should specifically provide that the outstanding principal balance is immediately due and payable upon the sale of substantially all of the assets of the maker or all of the ownership interest of the maker.
c) include a confessed judgment clause, in which the buyer authorizes a judgment to be entered against it if it is necessary to take the buyer to court. Rules and practices vary from state to state. Some states impose restrictions on confession of judgments (or even prohibit them entirely in certain kinds of transactions), but generally a confession of judgment complying with applicable state law will limit the defenses that a defaulting buyer can assert and give the seller a speedier remedy.
(5) Properly secure the promissory note and, if possible, obtain guarantees from the buyer, its owners and their spouses. Securing the note involves procedures and limitations that are similar to those involved when a bank seeks to secure its loan to a buyer. As is true in the case of bank financing, a security interest can be held in the proceeds of the sale. As a result, it becomes all the more important to establish a security interest in all of the other property’s assets and, if possible, have the buyer’s principals pledge their stock or other equity interests to the seller.
Like banks and other financial institutions, the seller should negotiate for protections to ensure that the buyer does not strip the property of its value. Thus, provisions should restrict compensation, dividends, capital distributions and other payments to the new owners, prohibit the sale of assets except in the ordinary course of business, and require the maintenance of specified minimum levels of working capital until the purchase price is paid. Bank financing usually will include other protections for the lender, such as requiring maintenance of specified ratios between cash flow and debt service that can give the lender an early warning if the borrower is not doing well. Sellers providing financing can also benefit from such protections, although there is often an expectation on the part of buyers and their counsel that seller financing will be much easier to deal with than bank financing. Some security agreements prohibit the purchaser from making major expenditures not customary in the ordinary course of the publication’s operation without the lender’s approval. The Commission also permits the loan documents to require the borrower, in the event of a default, to cooperate with the lender in the appointment of a receiver.
In addition to the guaranty of the business entity acquiring the property, the seller should ask for a personal guaranty from the buyer’s principals and their spouses. A personal guaranty is not a specific lien on any particular asset, but provides for personal liability as needed to pay the note. A personal guaranty, like a note, can also be secured by the pledge of specific assets; if the guaranty is not secured, it would be necessary to obtain a judgment against the guarantor before seizing the assets to satisfy the obligation. The spouse’s signature is needed to prevent the transfer of assets to the spouse to dilute the buyer’s net worth and to make sure that jointly owned assets will be available to pay a judgment.
If the buyer is able to obtain partial bank financing and the seller is compelled to subordinate payments to senior financing, the seller will need to enter into negotiations with the lender with regard to subordination and the relationship with each other with respect to the buyer and the collateral. The seller should seek to limit the depth of its subordination, including limitations on the principal amount of senior indebtedness, the interest rate on the senior indebtedness and amendments of the payment terms of the senior indebtedness, which have the effect of putting the payment of the subordinated seller financing at greater risk.
(6) Impose on the buyer post-closing obligations that protect the value of the property and permit the seller to monitor the property’s performance. Post-closing, the buyer should be required to keep the assets fully insured against fire, theft or vandalism and general liability until the note is paid. The seller also should be designated as an additional insured entity under the policy. The buyer should be required to inform the seller of any changes in coverage or a cancellation. To reassure the buyer, the insurance proceeds to the seller can be limited to the amount of remaining money owed on the note, with the balance going to other beneficiaries.
One of the principals of the buyer might be asked to take out a life insurance policy with the selling entity as the beneficiary in an amount equal to the unpaid balance of the note. Disability insurance policies on key members of the buyer’s management team might be considered, but they are not often used because of their expense.
The security agreement between the seller and the buyer should also require the buyer to provide property financials to the seller on a regular basis. In that way, the seller should have advance warning if the station is in financial trouble.
Permitting a buyer to defer the payment of a portion of the purchase price is a form of financing and, as such, carries with it significant risks. By taking the steps outlined above, however, the prudent seller can reduce those risks and help ensure that it is properly compensated for incurring them.
About the Authors
John R. Brooks is a 25-year broadcast finance veteran, most recently as a Managing Director with Wells Fargo Foothill. He currently works as an independent broadcast consultant and writer. He can be reached at email@example.com and (415) 272-5123.
Erwin G. Krasnow, the co-chair of the Communications Group of Garvey Schubert Barer, is a former General Counsel of the National Association of Broadcasters, a coauthor (with John M. Pelkey and John Wells King) of Profitably Buying and Selling Broadcast Stations and Washington counsel to the Media Financial Management Association. He can be reached at firstname.lastname@example.org and (202) 298-2161.