The private equity group wants us to carry a twenty percent seller note subordinated to their senior bank debt. How do we structure the subordination agreement and the covenants to protect our capital if the company performance tanks under their management?

Question

Tyler Smith · Accepted Answer

Carrying a subordinated seller note is common, but you must protect yourself from the buyer's operational incompetence. Because your debt will be junior to the senior bank lender, the bank will require a subordination agreement. This agreement often includes a payment blockage clause, meaning if the buyer defaults on their bank loan, they must stop paying you immediately.

To mitigate this risk, you must negotiate three critical protections. First, demand a high interest rate that reflects your risk level, with a portion paid in cash and a portion structured as payment-in-kind interest that accrues to the principal balance. Second, include strict financial covenants in your note that are identical to, or slightly tighter than, the senior bank covenants. If the buyer's leverage ratio exceeds a certain threshold, they are in default of your note, giving you a seat at the table before the senior lender forecloses.

Third, secure a personal guarantee from the buyer's principals or equity sponsors, or take a junior lien on the business assets. Use your historical financial metrics to establish these baselines. If you built a highly profitable business using clear operational disciplines like the weekly Scorecard, you know what healthy margins look like. Do not let the buyer run the company into the ground while you sit silently waiting for your subordinated payments.