The private equity sponsor is funding part of their acquisition with a senior bank loan and expects us to carry a twenty percent seller note that is fully subordinated. How do we structure our note terms and intercreditor agreement so we do not end up holding worthless, uncollectible debt?

Question

Tyler Smith · Accepted Answer

Senior commercial lenders will demand that your seller note takes a back seat to their acquisition debt. If you accept standard subordination language without negotiation, you will sign an intercreditor agreement that turns your seller financing into an uncollectible, unsecured gift to the buyer.

You must differentiate between standard lien subordination and deep payment subordination. Lien subordination simply establishes that the bank gets paid first from company assets if the business liquidates. That is standard. Deep payment subordination, where the bank can freeze your scheduled interest and principal payments whenever they want, is unacceptable.

Negotiate strict limits on payment blockage notices. The senior lender should only be permitted to block your note payments if the company is in an active monetary default on the senior debt, not a technical covenant breach. Furthermore, cap any payment blockage window at ninety to one hundred and twenty days maximum, with no more than one blockage permitted in any rolling twelve-month period. If the senior lender does not accelerate their loan when the blockage window expires, your cash payments must resume automatically, including all accrued catch-up payments.

Structure the note with compounding payment-in-kind interest so unpaid interest capitalizes into principal at a higher penalty rate. Secure a secondary security interest on the company's assets behind the senior lender, and insist on parent-level entity guarantees. Finally, build an operational default covenant: if the buyer fails to service your seller note, your intercreditor terms must allow you to exercise equity step-in rights or convert your note into senior preferred equity with board control to salvage the business before the bank forecloses.