In a lender-financed acquisition the seller note is usually a minority of the price, well below the senior loan, sized to close the gap between the price and what the lenders and the buyer's equity provide. It is subordinated to the senior loan under a subordination or intercreditor agreement, usually matures after it, and its payments can be blocked if the company defaults or misses a covenant. Its rate is negotiated, and interest may be paid in cash or added to the balance. The useful question is not the note's size but how it sits behind the senior debt.
- Typical size
- A minority of the price, well below the senior loan
- What sets the size
- The gap between the price and senior debt plus the buyer's equity
- Ranking
- Subordinated to the senior loan by a subordination or intercreditor agreement
- How lenders read it
- A seller who defers part of the price believes in the cash flow
- What matters most
- Payments, blockage, standstill and maturity relative to the senior loan
What decides the size of the note
There is no standard share of the price that a seller carries. The note is a plug, and its size falls out of three other numbers: the price, the most the lenders will provide against the company, and the equity the buyer brings. When senior debt and equity cover the price, the seller note can be small or absent. When the lenders size below the price, because the earnings support less debt than the seller hoped, the seller is asked to carry the difference or lower the price.
That is why, in deals financed by a bank, a private credit fund or a unitranche lender, the seller note is almost always a minority of the price and well below the senior loan. Senior cash-flow lenders to lower-middle-market companies commonly lend 2x to 3.5x EBITDA, and the seller note sits between that loan and the buyer's equity. The senior lender will only let it be as large as the company can carry alongside the senior debt. In deals without a senior lender, where the seller finances most of the price, the note can be much larger; that is a different trade, compared on seller financing vs bank financing.
A seller note competes for the same slot as other junior capital. Mezzanine costs more and comes with a fund's terms; rollover equity leaves the seller owning part of the company instead of being owed money. Many deals use more than one.
Rate, term and amortization
Seller notes are negotiated, not priced off a market, so their terms vary more than bank loans do. The patterns lenders see most often:
- Rate. Negotiated, and it varies widely. Junior risk argues for a rate above the senior loan's, but many sellers who want the deal done, or who want to see the company continue, accept less than a junior lender would charge.
- Cash or PIK interest. Interest may be paid currently in cash, or added to the balance and paid at maturity. Senior lenders often prefer PIK interest on seller paper, or allow cash interest only while covenants are met.
- Amortization. Level payments, interest-only followed by a balloon, or a single payment at maturity. Each has a very different effect on the first years' cash flow.
- Maturity against the senior loan. Senior lenders commonly require the note to mature after their loan, so that it cannot demand repayment while the senior debt is outstanding.
- Security and guarantee. The seller may take a junior lien, subject to the senior lender's approval and ranking behind it. Many seller notes are unsecured.
The terms that most concern a senior lender are covered in seller note terms in conventional deals.
Why lenders like to see one
A seller who agrees to be paid later, and behind the lender, is saying something the financial statements cannot: that they expect the company to keep producing cash after they leave. Lenders read a seller note as that signal. It matters most where the company depends on the founder's relationships, where earnings have recently improved, or where the buyer is new to the industry. It also gives the buyer recourse: a note with setoff rights can be reduced if the seller's representations turn out to be wrong; see escrow and holdback in acquisition financing.
The reverse is also read. A seller who insists on every dollar in cash at closing does not disqualify a deal, but lenders notice it and ask why. A seller who wants contingent payment instead is proposing an earnout; the difference between the two instruments is on earnout vs seller note.
The real question: how the note sits behind the senior debt
Two notes of the same size can make a deal work or break it, depending on how they are written. What a senior lender looks at is whether the note can take cash out of the company while the senior loan is outstanding, and what happens if the company struggles.
| Term | What the senior lender asks for | Why it matters to the company |
|---|---|---|
| Payment blockage | No payments on the note after a senior default; after a covenant default, a block for a set period | Cash stays in the company when it is most needed |
| Permitted payments | Scheduled interest, and sometimes principal, allowed only with no default and covenants met after payment | The seller is paid on schedule in normal years |
| Standstill | The seller cannot accelerate, sue or enforce for a set period after a default | A dispute with the seller cannot force the company into a crisis |
| Maturity | After the senior loan | The note cannot come due first and force a refinancing |
| Amendments | No changes to the note's terms without the senior lender's consent | The seller cannot be paid faster by a side agreement |
| Leverage treatment | Counted in total leverage, not in senior leverage | The note uses up the total-debt headroom in the covenants |
These terms live in a subordination agreement the seller signs with the senior lender, or in an intercreditor agreement where the note is secured. Sellers most often misunderstand them. A seller who first sees them at closing can refuse to sign, and the deal stalls. The full set of terms is covered in seller note subordination terms.
Agree the note's subordination terms in the letter of intent. A note whose terms the senior lender will not accept has to be renegotiated, and that happens at the worst moment.
A worked example: same note, different result
A company produces 1,500 a year of cash flow available for debt service, and its senior debt service is 1,000. Conventional bank lenders commonly look for coverage of at least 1.25x, so total debt payments must stay at or below 1,200. The seller is carrying a note of 1,000. How it is written decides whether the structure passes.
| How the seller note is written | Note payments a year | Total debt payments | Clears 1.25x on 1,500? |
|---|---|---|---|
| Amortizing over a short term | 300 | 1,300 | No: 1,500 against 1,300 |
| Interest-only in cash, principal at maturity after the senior loan | 80 | 1,080 | Yes: 1,500 against 1,080 |
| PIK interest, principal and interest at maturity after the senior loan | None | 1,000 | Yes: 1,500 against 1,000, but the balance grows |
The first row carries the same debt as the other two and fails coverage, because the note is repaid much faster than the senior loan. The second passes comfortably. The third passes with the most room, but its balance grows every year and has to be repaid or refinanced when it matures, and lenders count that growing balance in total leverage. Nothing changed but the terms. How coverage is calculated is on debt service coverage ratio.
Negotiating the note
- Start from the lenders' number. The senior debt the company supports fixes the gap. Sizing the note before knowing it is guessing.
- Trade rate for patience. A seller asked to wait behind the lender is usually compensated through the rate or accrued interest, not through earlier payments.
- Put the subordination in writing early. Payment blockage, standstill and maturity terms belong in the letter of intent.
- Keep setoff rights. The right to reduce the note for breaches of the seller's representations protects the buyer without a separate escrow, if the senior lender's agreement allows it.
- Plan the payout. Some seller notes are paid off early when the senior loan is later refinanced; see refinancing a seller note.
Midas Partners's financing model shows coverage and leverage with and without each seller note's payments, so the size and terms of the note are settled against the lenders' tests before a lender reads the file. The full package is built in a day once the documents are in, and a senior banker checks every page before the client approves it. What the model contains is on the package.
Common questions
- Is there a standard percentage of the price a seller finances?
- No. The note is sized to the gap between the price and the senior debt plus the buyer's equity. In lender-financed deals it is usually a minority of the price, well below the senior loan.
- Can the seller be paid while the senior loan is outstanding?
- Usually, yes, on the note's schedule, but only under the subordination agreement: payments stop if the company defaults, and often if it misses a covenant, until the problem is cured.
- Does a seller note count as debt or equity to the lender?
- Debt. It counts in total leverage, though not in senior leverage. Some lenders give a deeply subordinated note with no cash payments some credit as junior capital, but it is their call.
- What interest rate do seller notes carry?
- It is negotiated, and there is no market rate. Junior risk argues for more than the senior loan pays, but sellers keen to close often accept less. Interest may be paid in cash or added to the balance.
- Why would a lender want the seller to carry a note?
- A seller willing to be paid later, and behind the lender, is signaling that the company will keep performing after the sale. Lenders weigh that most heavily where the company depends on the founder.