A buyer is asking us to carry a twenty percent seller note, claiming their senior lender demands it. How do we structure the subordination terms and interest rates of this seller financing so we do not end up holding all the risk for zero upside?

Question

Tyler Smith · Accepted Answer

Seller notes are common because senior lenders want the seller to have skin in the game post-close. However, being subordinate to a senior bank means you are last in line if things go sideways. To balance this risk, you must negotiate terms that compensate you for acting as a junior lender.

Start by negotiating a higher interest rate than the senior debt. Since your risk is higher, your return must reflect it. If the cash flow of the business cannot support cash interest payments initially, use a payment-in-kind structure where the interest accrues and compounds into the principal balance of the note.

Next, negotiate the subordination agreement carefully. Limit the block payment period, which is the window of time the senior lender can halt payments to you if the buyer defaults on the senior loan. Insist that this block period cannot exceed ninety days, and prevent the bank from blocking your payments more than once in any twelve-month period.

Finally, negotiate equity conversion rights or warrants. If you are taking equity-like risk by financing the transition, you deserve equity-like upside. If the buyer hits certain growth milestones, your note should convert into a minority equity position or trigger a success fee. This turns a structural risk into a highly profitable investment.