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 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?
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:
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:
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?
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.
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:
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.
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