The buyer wants us to carry a twenty percent seller note to help secure their senior bank financing, but we are worried about standing in line behind the lender. How do we structure a seller note to protect our principal and minimize default risk?

Question

Tyler Smith · Accepted Answer

A seller note is frequently used to bridge a valuation gap or satisfy a senior lender requirement for equity cushion. However, senior commercial lenders will always demand that your note be fully subordinated. That means if the acquired business stumbles, the bank can freeze your interest and principal payments while their debt gets serviced first. You end up absorbing junior mezzanine risk without getting mezzanine equity upside.

To protect yourself, negotiate the intercreditor agreement directly. Insist that payment standstill periods are strictly capped. If the buyer defaults on their senior loan, the bank should only be allowed to block your seller note payments for ninety to one hundred twenty days, not indefinitely. Once that standstill period expires, you must retain the legal right to enforce your remedies unless the bank has formally initiated foreclosure proceedings.

Second, build protective covenants into your note agreement. Require quarterly financial reporting and covenant compliance certificates so you can see cash flow deterioration before a full default occurs. Mandate an interest rate that compensates for your risk, typically eight to twelve percent, with a paid-in-kind option permitted only during documented, temporary operational emergencies.

Third, demand real security. If you cannot secure a second lien on the operating assets, secure the note with a pledge of the buyer holding company stock or a personal guarantee from the acquiring principals. If the buyer is an independent sponsor or search fund without institutional backing, never allow their corporate management fees to be paid ahead of your seller note interest.