Is the Promissory Note in Your Buy-Sell Agreement Fair to All Parties?

What is a promissory note? According to Investopedia, a promissory note is:

A written, dated and signed two-party instrument containing an unconditional promise by the maker to pay a definite sum of money to a payee on demand or at a specified future date.

Promissory notes are used frequently as a funding mechanism when buy-sell agreements are triggered. However, most buy-sell agreements reflect very little thought or negotiation regarding the promissory notes that they contain.

Typical Shareholder (Promissory) Note Language

Typical text describing a promissory note in a buy-sell agreement might include language similar to the following:

In payment of the Purchase Price determined by the appraisal process (Section 3), the Company will make an immediate cash payment of 20% of said purchase price at closing of the sale transaction. In addition, the Company will issue a Promissory Note for the remainder of the Purchase Price. The promissory note will have the following terms: (a) The interest rate shall be the prime rate of Bank of America on the date of closing, which will fix the rate until the Promissory Note is repaid in full; and, (b) The Promissory Note will be amortized with payments by the Company of equal quarterly installments of principal and interest for twenty quarters (five years), payable on the last day of each succeeding fiscal quarter following the date of closing, or until prepaid in full, at the Company’s option. If the Company prepays the Promissory Note, it will make a final payment of remaining principal and accrued interest to the date of payment. There shall be no prepayment penalty if prepayment is made.

The language above reflects a composite of language from reading many buy-sell agreements. While there are a few agreements that provide more specificity for promissory notes, the great majority, at least in my experience, are similar to the language above. So what’s the problem? Or is there one?

What is Missing?

The Promissory Note (or Shareholder Note) described above appears to have been developed with a goal of maintaining flexibility for the Company issuing it. Potential sellers of stock, i.e., individual shareholders who might one day sell stock pursuant to the buy-sell agreement, were apparently not present when the note terms were documented.

The Promissory Note is almost assuredly junior to the Company’s bank debt, and therefore, fairly obviously, more risky. This extra riskiness will be recognized by the holder of the Promissory Note over its duration. Higher risk occurs because of (at least) the following:

• There is no provision that the holder of the Promissory Note gets even a second collateral position in the Company’s assets (behind the bank).
• There is no provision for any guarantee by any of the other shareholders, who are beneficiaries of the repurchase.
• There is no enumeration of events of default, and there are no protections for the holder of the Promissory Note in the event of a default by the Company. For example, there is no right to demand acceleration of payment in the event of default.
• There is no requirement that the Promissory Note be repaid in the event that the Company is sold or merges with another entity.
• There is no protection to insure that the Company does not issue additional debt senior to the Promissory Note, therefore potentially increasing its riskiness even more.
• There is no provision for interest on the value of any equity ownership position between the date of the trigger event and the date of closing.
• There is no provision as to whether the interest will receive dividends between the trigger date and closing.
• From the Company’s viewpoint, there is no clarification whether the stock will vote during the period between the trigger date and closing.

A Closer Look at the Promissory Note

Let’s make the following assumptions about the situation when this Company’s buy-sell agreement is triggered and a 10% interest of its equity is involved:

• The fair market value of the Company per the appraisal rendered two months prior to the trigger date, which sets the price for the buy-sell agreement, is $10.0 million.
• The 10% interest is therefore worth $1.0 million, or its pro rata share of the equity value of the enterprise.
• The Company is required to make a down payment of $200 thousand and will issue a Promissory Note in the amount of $800 thousand. Bank of America’s prime rate is 6.0% on the date of the trigger event. The quarterly amortization on the note for twenty months is therefore $45,596.59.
• The Company’s borrowing cost is prime plus 2%.
• The Company has $4.0 million of debt on its balance sheet financed by a local bank. The bank has a security interest in all of the Company’s assets and no debt can be issued that is senior to the bank’s position without the bank’s permission (which is almost certainly not forthcoming).

A simplistic analysis suggests that the fair market value of the Promissory Note is less than its $800 thousand face value. With the Company’s existing borrowing cost at 8% (prime of 6% plus 2%), assume for illustration that an incremental risk premium (relative to the Company’s existing borrowing cost) of 2% would be sufficient to compensate hypothetical investors for taking on the risks associated with the Promissory Note (which yields 6%). This would suggest that the appropriate interest rate for the Promissory Note is 10% (8% plus 2%).

Under these assumptions, what is the fair market value of the Promissory Note?

• Number of Periods
  N = 20 (5 years x 4 quarters per year)

• Interest Rate
  I = 2.5% (10% / 4 quarters)

• Payment
  P = $45,596.59

• PV = Fair Market Value
  FMV = $726,401.78

Under these assumptions, the fair market value of the Promissory Note with a face value of $800 thousand is $726 thousand, which reflects a 9.2% discount to face value. Given the cash payment, the shareholder would receive consideration with a total fair market value of $926,401.78, or 7.4% less than the fair market value of the stock that was sold.

Conclusion

Promissory notes issued pursuant to the operation of buy-sell agreements are fairly common and often do not provide equivalent fair market value for the stock that is sold by shareholders. This raises a number of issues:

• For companies. The promissory note found in your buy-sell agreement may provide flexibility to the company if and when issued in a transaction. However, the question remains, is it “fair” and reasonable for all shareholders?
• For shareholders who remain after a transaction. You will benefit from the repurchase with favorable (to the company) financing for the purchase. That’s positive, perhaps.
• For the selling shareholder. Selling shareholders do not receive what they bargained for, i.e., the fair market value of their stock when sold at a trigger event. That’s certainly not positive from their perspectives.
• For all shareholders. There is risk here since no one knows in advance who will be the selling shareholder.

It is a good idea to look at the promissory note in your buy-sell agreement (or your clients’ buy-sell agreements) to determine if it is reasonable for all the parties under reasonably foreseeable circumstances.