The buyer has an aggregate valuation gap and wants us to hold a subordinated seller note for 15 percent of the enterprise value. How should we structure the terms, interest rates, and subordination agreements to ensure we actually get paid?

Question

Tyler Smith · Accepted Answer

A seller note is one of the most common gap-financing mechanisms in lower middle market M&A. Buyers use it to stretch their leverage capacity, reduce their equity check, and keep the seller financially committed to a smooth transition. When a buyer asks you to carry a seller note for 10 to 20 percent of enterprise value, they are asking you to function as an unrated merchant bank.

The first critical term to address is the intercreditor agreement and debt subordination. Senior lenders will almost always demand that your seller note be fully subordinated to their commercial credit facility. This means if the business experiences a covenant breach or liquidity shortfall post-close, the bank will trigger a standstill agreement that freezes all interest and principal payments to you for anywhere from 90 to 180 days or longer.

To protect your capital, negotiate a competitive interest rate that reflects your junior risk profile, typically between 8 and 12 percent. If cash flow is tight, structure the note with a combination of current cash pay interest and payment-in-kind interest that compounds into the principal balance.

Next, set hard limits on the standstill duration. If the senior lender freezes payments, that freeze must expire after a maximum of 120 days unless the senior debt is in actual bankruptcy or active foreclosure.

Furthermore, the note must include robust default covenants: failure to pay triggers penalty interest rates, an immediate seat on the board of managers, or the right to demand equity acceleration. Never allow a buyer to offset earnout disputes or indemnification claims against your seller note unless an independent arbitrator has issued a binding final judgment.