The buyer wants us to carry an unsecured seller note at a below-market 6 percent interest rate to make their bank underwriting work. How can we use equity warrants or payment-in-kind interest to balance the risk of carrying low-yield seller debt?

Question

Tyler Smith · Accepted Answer

Carrying an unsecured seller note at six percent when commercial paper and senior debt yields are higher means you are subsidizing the buyer leverage without receiving fair compensation for your subordinated risk position. If you take mezzanine-level risk, you must capture mezzanine-level economic returns.

When a buyer cannot increase their cash interest rate because the senior bank enforces strict fixed-charge coverage limits, introduce payment-in-kind (PIK) interest. Structure the note with a six percent cash interest coupon paid monthly to stay inside senior lender underwriting constraints, combined with an additional four to six percent PIK interest that accrues and capitalizes directly into the principal balance of the note, compounded annually. This protects the company cash flow post-close while ensuring your total yield reflects subordinate risk upon maturity or payoff.

To bridge an even wider valuation gap, attach detachable penny warrants to the seller note. Negotiate warrants that grant you the right to purchase two to five percent of the buyer company common equity for a nominal exercise price upon a subsequent change of control or recapitalization. If the buyer scales the business successfully, your warrants generate substantial equity upside that compensates for the concession you made at close.

Require standard credit protections alongside these structures, including a mandatory prepayment penalty if the buyer refinances senior debt, accelerated maturity upon any subsequent ownership change, and cross-default clauses tied to senior credit facilities. If the buyer rejects both PIK interest and equity warrants, reduce the face value of the seller note and demand a higher upfront cash consideration at close.