The buyer is asking for a seller note to fund 20 percent of the purchase price, but they want it fully subordinated to their senior bank lender. How do we structure the subordination agreement and default remedies to prevent our note from being frozen if they violate a bank covenant?

Question

Tyler Smith · Accepted Answer

Accepting a seller note means you are essentially acting as a bank, but without a bank's inherent leverage. When a buyer requests that your note be fully subordinated to their senior acquisition lender, they are asking you to assume significant risk for their debt obligations. If the company fails to meet a senior debt covenant after the transaction closes, the senior lender will typically immediately block your interest payments, thereby freezing your cash flow.

To mitigate this risk and protect your investment, you must negotiate a robust subordination agreement that includes clear safeguards.

Key Protections for Your Seller Note

Here are critical components to include in your subordination agreement:

• Payment Blockage Cap: Demand a specific limitation on the senior lender's ability to block your payments. This provision should cap the blockage period to a maximum of 120 or 150 days within any rolling twelve-month period. This prevents an indefinite freeze of your cash flow and ensures that payments will eventually resume. For more insights on financial preparations, consider [cleaning up your financials for a business sale valuation](/qa/cleaning-financials-for-business-sale-valuation).

• Independent Default Definition: Clearly define what constitutes a default on your note separately from the senior bank covenants. If the buyer defaults on payments owed specifically to you, your subordination agreement should allow you to accrue unpaid interest at a default rate. This rate should be at least five percentage points higher than the base interest rate, providing a stronger incentive for timely payment. This is crucial for [understanding business valuation multiples](/qa/understanding-business-valuation-multiples-market-approach) and ensuring fair terms.

• Collateral and Guarantees: Secure your note with a junior lien on the company's assets. Additionally, obtain a personal guarantee from the buyer's principals. These measures provide alternative avenues for recovery if the company defaults. When considering the buyer's financial health, it's also wise to assess [operational risks before buyer due diligence](/qa/identifying-operational-risks-before-buyer-due-diligence).

• Springboard Provision: Negotiate a springboard provision as a critical remedy if the buyer fails to cure a default on your note. This provision grants you the right to:
• Reclaim a seat on the board of directors.
• Appoint an independent observer to oversee the company's operations.

This ensures you remain informed and have the legal standing to protect your principal investment before the business's value significantly degrades. This can be a vital safeguard, much like [mitigating customer concentration risk in valuation](/qa/mitigating-customer-concentration-risk-in-valuation) protects overall enterprise value.