The buyer wants us to take a seller note to bridge a twenty percent valuation gap, but they refuse to allow any interest payments to accrue during the first two years. How do we structure the note to protect our yield and security?

Question

Tyler Smith · Accepted Answer

Accepting a seller note with no interest payments for the first two years is highly risky, as it essentially means you are providing the buyer with an interest-free loan while carrying all the default risk. If you must use a seller note to bridge a valuation gap, you must structure it to protect your financial yield and secure your position. First, negotiate for a paid-in-kind interest mechanism. If the buyer cannot support cash interest payments during the first two years due to senior bank covenants, agree that the interest will accrue and compound annually, adding to the principal balance of the note. This ensures you are compensated for the time value of your money. Second, secure the note with a secondary lien on the company's assets, ranking immediately behind the primary bank. Do not accept an unsecured position. Third, include strict financial covenants in the note agreement. If the business misses its targets or takes on excessive debt, it should trigger an immediate default, allowing you to accelerate the note or regain equity control. Finally, coordinate this with your Section 453 installment sale tax planning to ensure your tax liabilities match your cash receipts. By converting an interest-free demand into a structured, compounding note with strong collateral, you protect your exit proceeds and force the buyer to treat your seller debt with the same seriousness as senior bank debt.