To bridge a two-million-dollar valuation gap, the buyer wants us to accept a seller note with a payment-in-kind interest rate, but our attorney is worried about default risk. How do we structure this note to protect our payout?

Question

Tyler Smith · Accepted Answer

A seller note is a powerful tool to close a valuation gap, but a payment-in-kind interest structure means the buyer pays interest in additional debt rather than cash, compounding the principal until maturity. This increases your risk because you are deferring cash payments while the business takes on more leverage. To protect your payout, you must negotiate strong debt covenants and clear subordination terms. First, look at the subordination agreement with the buyer's senior lender. While the senior bank will always have priority, you must negotiate block-payment provisions. This ensures that as long as the buyer is not in default on their senior bank loan, they are legally permitted to make their scheduled payments to you. Next, insist on financial covenants within your seller note. These should mirror the senior lender's covenants, such as maintaining a maximum debt-to-EBITDA ratio and a minimum interest coverage ratio. If the buyer breaches these covenants, it should trigger an automatic default on your note, giving you the right to accelerate the payments or take action. You should also secure the note with a secondary lien on the company's assets or require a personal guarantee from the buyer's principals if you are dealing with an individual search fund. Finally, include a covenant that prevents the buyer from paying out dividends to their equity investors or making major acquisitions until your seller note is fully paid off. This ensures that cash flow is prioritized for debt service, protecting your hard-earned valuation from being siphoned away by the buyer.