A private equity buyer wants us to carry a twenty percent seller note amortized over seven years at five percent interest, but senior bank rates are eight percent. How do we structure the seller note interest rates, amortization schedule, and balloon payments so we are properly compensated for secondary risk?

Question

Tyler Smith · Accepted Answer

A seller note is junior debt. If the buyer is paying eight percent to a senior bank holding first-lien rights on all assets, asking you to accept five percent on unsecured or deeply subordinated paper is an uncompensated transfer of risk. You are subsidizing their acquisition yield while absorbing equity-like downside.

To structure a seller note that reflects market reality, deploy these specific mechanics:
- Price interest at a spread above senior debt. Secondary paper typically commands senior rate plus two to four percent. If the bank charges eight percent, your note should yield ten to twelve percent.
- Use interest rate step-ups. If the buyer cannot support a high cash coupon on day one, structure the note to start at seven percent in year one and step up by one hundred basis points every twelve months. This creates a powerful operational incentive for the buyer to refinance you out early.
- Shorten the amortization schedule with a balloon. Avoid seven-year payout horizons. Contract for a three to five year term with payments amortized over seven or ten years, culminating in a mandatory balloon payment at the end of month thirty-six or sixty.
- Require payment-in-kind (PIK) compounding. If senior lender covenants block cash interest distributions due to leverage limits, require all unpaid interest to capitalize into the principal balance monthly rather than forgiving or pausing it.
- Secure a parent guarantee or secondary lien. Subordination does not mean abandonment. Secure a second-lien pledge on company equity or an unconditional personal or fund-level guaranty from the buyer entity.

If the buyer refuses market terms, treat the gap as an IDS issue in your deal negotiations. Do not provide bargain leverage to a financial buyer.