The buyer wants us to take a seller note for thirty percent of the purchase price but insists it must be fully subordinated to their senior bank debt. How do we structure protective covenants to prevent a total loss if the buyer defaults on their primary loan?

Question

Tyler Smith · Accepted Answer

Subordination is a reality in mid-market deals, but complete subordination without guardrails is a recipe for disaster. If the buyer defaults on their bank loan, senior lenders will block all payments on your seller note. You must negotiate specific carveouts in the subordination agreement before signing the letter of intent.

First, secure a block payment exception. This allows interest payments to continue to you as long as the senior borrower is in compliance with their bank covenants. If a technical default occurs under the senior loan, negotiate a payment blockage period capped at ninety days. Once that period ends, payments to you must resume unless the senior lender has initiated formal foreclosure proceedings.

Second, tie your note protections to your operational frameworks. Require the buyer to provide quarterly financial statements and covenant compliance certificates. If their debt service coverage ratio drops below a defined threshold, your note should trigger an automatic interest rate step-up.

Finally, include an equity conversion right upon default. If the buyer defaults and cannot pay, your debt should convert into preferred equity or senior voting shares. This gives you the right to reclaim operational control of the company or take a seat on the board. This structure protects your proceeds while giving the senior lender the priority they require.