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 acting as a bank, but without a bank's leverage. When a buyer demands that your note be fully subordinated to their senior acquisition lender, they are asking you to take on all the risk of their debt load. If the company misses a senior debt covenant post-close, the senior lender will immediately trigger a block on your interest payments, freezing your cash flow.

To protect yourself, you must negotiate a smart subordination agreement with clear guardrails. First, demand a payment blockage cap. This limits the senior lender's ability to block your payments to a maximum of 120 or 150 days in any twelve-month period, preventing an indefinite freeze.

Second, define what constitutes a default on your note independently of the senior bank covenants. If the buyer defaults on your payments, your subordination agreement should allow you to accrue unpaid interest at a default rate that is at least five percentage points higher than the base rate.

Third, secure the note with a junior lien on the company's assets and a personal guarantee from the buyer's principals. If the buyer fails to cure a default, negotiate a springboard provision. This remedy gives you the right to reclaim a seat on the board of directors or appoint an independent observer to oversee operations. This keeps you in the loop and gives you the legal teeth to protect your principal before the business degrades.