The buyer wants us to carry a fifteen percent seller note subordinated to senior bank financing, and their credit agreement prevents cash interest payments if debt service ratios slip. How do we structure payment-in-kind interest and standstill provisions to protect our principal?

Question

Tyler Smith · Accepted Answer

Senior commercial lenders will always demand priority over seller financing. If the buyer underperforms and their senior debt service coverage ratio falls below bank covenant levels, the bank will trigger a payment blockage that halts your monthly cash interest and principal payments. Carrying a subordinated note without rigid defensive covenants exposes you to indefinite payment freezes while the buyer continues operating.

To protect your note against institutional subordination, establish clear baseline rules during intercreditor negotiations:

- Mandate Payment-in-Kind interest. If the senior lender issues a blockage notice prohibiting cash payments, the purchase agreement must state that all unpaid interest automatically capitalizes into the note principal and compounds monthly at a penalty rate of two to four percent above the baseline coupon.
- Cap senior lender standstill periods. Do not sign an open-ended subordination agreement. Limit the bank's contractual blockage period to a maximum of ninety to one hundred and twenty consecutive days within any rolling twelve-month period. Once the standstill expires, cash payments must resume automatically, or you must be permitted to exercise seller remedies.
- Secure a junior security interest on the company's enterprise assets and an equity pledge of the holding company units. While the bank sits in senior position, having junior liens ensures you have a recognized seat at the table if a restructuring occurs.
- Require the buyer to provide quarterly financial statements, including trailing twelve-month balance sheets and bank covenant compliance certificates, within thirty days of each quarter end.

When a buyer uses your balance sheet to complete their capital stack, your seller note should act like institutional mezzanine debt, not an interest-free insurance policy for their acquisition bank.