A private equity buyer wants to acquire our company but faces commercial lending limits that leave a $2 million gap in their capital stack. How can we use a subordinated seller note with PIK interest to bridge their debt service coverage requirements while protecting our return?

Question

Tyler Smith · Accepted Answer

When commercial banks underwrite an acquisition, they limit senior debt based on conservative debt service coverage ratios (DSCR), often leaving a shortfall between their lending capacity and your enterprise valuation. If a buyer cannot fill that gap with common equity, a subordinated seller note with Payment-in-Kind (PIK) interest provides a practical mechanism to close the transaction without reducing your price.

Under a PIK structure, the note does not require monthly cash principal or interest payments. Instead, the interest accrues and compounds directly onto the outstanding note principal each quarter. Because the note demands zero cash flow from the operating company during the loan term, the senior commercial lender will exclude the note payments from their ongoing DSCR calculation, allowing the senior loan to fund.

To protect your economic interests when carrying subordinated PIK debt:
- Demand a premium interest rate. Because you are deferring cash payments and taking structural risk behind a commercial bank, standard PIK interest rates should range from ten to fourteen percent annually.
- Negotiate springing cash-pay triggers. Structure the note so that once the buyer reduces senior debt leverage below a specified ratio, a portion of the PIK interest automatically switches to monthly cash payments.
- Align maturity dates. Ensure your seller note maturity date extends at least six months past the senior bank debt maturity, but mandate an accelerated prepayment requirement if the buyer refinances their senior facility or sells the company.
- Limit owner distributions. Restrict the buyer from pulling equity distributions, paying discretionary management fees, or acquiring other businesses until your accrued principal and interest are paid in full.

This structure allows you to capture your desired headline valuation while compounding a high yield on deferred proceeds.