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 a common component in private equity transactions, but it requires careful structuring to protect your capital. Because your debt will be junior to the senior bank lender, the bank will invariably require a subordination agreement.

This agreement typically includes a payment blockage clause, which means that if the buyer defaults on their senior bank loan, they must immediately cease all payments to you. This scenario leaves your capital at significant risk if the company's performance declines under the new ownership.

Protecting Your Seller Note

To mitigate the risks associated with a subordinated seller note, you must negotiate several critical protections into your agreement:

• High Interest Rate: Demand a high interest rate that accurately reflects your increased risk level. This rate should ideally be structured with:
• A portion paid in cash, providing immediate returns.
• A portion structured as payment-in-kind (PIK) interest, which accrues to the principal balance, deferring cash payments but increasing your total return over time.
• Strict Financial Covenants: Include robust financial covenants in your note agreement. These covenants should be:
• Identical to, or even slightly tighter than, the covenants imposed by the senior bank lender.
• Designed to trigger a default on your note if the buyer's financial metrics, such as their leverage ratio, exceed a predetermined threshold.
• Crucially, these covenants should give you a seat at the table and the ability to intervene before the senior lender can foreclose, offering an early warning system.
• Collateral and Guarantees: Secure your note with additional forms of protection:
• A personal guarantee from the buyer's principals or equity sponsors, making them personally liable for the debt.
• A junior lien on the business assets, providing you with a claim on the company's assets behind the senior lender.

Establishing Baselines and Maintaining Oversight

When negotiating these terms, leverage your company's historical performance. If you've built a highly profitable business with clear [operational disciplines](/qa/why-buyers-pay-more-for-eos-run-businesses) and strong metrics, use that data to establish realistic yet protective baselines for your covenants. For instance, your historical Scorecard metrics can demonstrate what healthy margins and [operational risks](/qa/identifying-operational-risks-before-buyer-due-diligence) look like, providing a strong basis for your demands.

Do not allow the buyer to run the company into the ground while you passively await your subordinated payments. Proactive monitoring and well-defined covenants are essential. For further insights, you might want to review [structuring seller notes](/qa/structuring-seller-notes-subordination-remedies) for additional remedies.

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