Seller paper is usually the cheaper and more flexible way to fill an acquisition gap: the rate is negotiated with someone who wants the deal to close, warrants are rare, and senior lenders will often accept deep subordination. Its limit is how much the seller will carry and on what terms. Mezzanine scales to the size of the gap and does not depend on the seller, but it brings covenants, warrants, prepayment premiums and a real cost of capital, and its cash interest weighs on the coverage the senior lender tests. Many deals use a seller note first and mezzanine only for what the seller will not carry.
- Usual cost
- Seller note: usually lower, rarely with warrants. Mezzanine: higher, often with warrants
- Size limit
- Seller note: what the seller will accept. Mezzanine: what the cash flow and the lender's minimums support
- Subordination
- Seller note: often deep, with a long standstill. Mezzanine: negotiated, with a limited standstill
- A note on standby
- Pays nothing while the senior loan is outstanding, so it leaves coverage untouched
- Senior lender's view
- Both usually count in total leverage; cash payments on either count in coverage
The gap, in numbers
A buyer agrees to pay 8,000 for a business earning EBITDA of 1,600. A senior lender will lend 4,800, inside the range senior cash-flow lenders commonly lend, which is 2x to 3.5x EBITDA. The buyer has 2,000 of equity. That leaves 1,200 to find.
There are two usual answers. The seller can take part of the price as a promissory note, paid over time after closing. Or a mezzanine lender can lend the 1,200 behind the senior lender. Either closes the gap on paper. They differ in what they cost, who controls the terms, how the bank sees them, and what happens if the business has a bad year. For the broader question of how much sellers typically carry, see how much seller financing is typical.
Side by side
| Factor | Larger seller note | Mezzanine debt |
|---|---|---|
| Who sets the terms | Negotiated with the seller as part of the price | Set by a professional lender pricing to its fund's return |
| Cost | Usually lower; often interest-only or lightly amortizing | Higher cash interest, often PIK, often warrants and fees |
| Size | Limited by what the seller will carry | Scales with the gap, subject to cash flow and the lender's minimum deal size |
| Subordination | Usually deep: payments blocked on default, long or permanent standstill | Negotiated intercreditor: payments blocked on default, limited standstill |
| Covenants | Few or none | Financial covenants set behind the senior lender's |
| Prepayment | Usually open; some sellers accept a discount for early payoff | Commonly carries prepayment premiums in early years |
| Senior leverage math | Counts in total leverage at most lenders | Counts in total leverage |
| Senior coverage math | Cash payments count; a note on full standby may be excluded | Cash interest counts; PIK does not, but grows the balance |
| Equity cushion | Some lenders credit a deeply subordinated, non-paying note toward it | Counted as debt, not cushion |
| If the business struggles | Seller is a motivated party who knows the business; recourse is limited | Lender with enforcement rights after its standstill |
Cost: why seller paper is usually cheaper
A mezzanine lender prices to a return its investors expect for junior risk. That return comes from cash interest, often some PIK interest added to the balance, an arrangement fee, and often warrants that give it a slice of the equity. Its money also tends to be locked in: prepayment premiums in the early years protect the lender's return if the buyer refinances.
A seller prices differently. The seller's alternative is not another loan but a lower price or no deal, and the note is how they get the price they want. Seller notes are therefore usually priced below mezzanine, rarely carry warrants, and are often interest-only for a period with a balloon at the end. Many can be prepaid without penalty, and some sellers will accept a discount for an early payoff. Sellers can also benefit from spreading the tax on their gain over the years the note is paid, under installment-sale treatment; that is a point for the seller's tax adviser, but it is one reason sellers accept paper at all.
The cheaper option still has a price. A seller who carries a larger note often negotiates a higher headline price in return, and the buyer should compare the two structures on total consideration, not just the note's rate. See earnout vs seller note for the other common way to bridge a valuation gap.
The seller's incentives, and their limits
A seller note ties part of the seller's proceeds to the business doing well after closing. Lenders like that: a seller willing to carry paper is signaling confidence in the earnings they are selling, and a seller with money still in the business has a reason to make the transition work. That signal is part of why senior lenders often prefer some seller paper in a deal.
The limits are real. Many sellers are retiring and want cash, and a note is a loan to a buyer they barely know, subordinated to a bank. The larger the note, the more the seller will push back on the terms the senior lender requires:
- Payments blocked whenever the senior loan is in default, or until the business passes a coverage test.
- A standstill that stops the seller from suing or accelerating while the senior loan is outstanding.
- No security, or security only behind the bank's.
- No right to take the business back if the buyer defaults.
Sellers often ask for a personal guarantee from the buyer, security in the business and cross-default rights instead. Some of that a senior lender will accept, some it will not. Where the seller will not accept the bank's terms, the note either shrinks or the deal needs another source. See what subordination terms a senior lender will require on a seller note and seller note terms in conventional deals.
A seller also has to accept that the senior lender will read the note before it reads the price. A note that pays monthly from closing, carries its own covenants or can accelerate on a default under the senior loan is, to the lender, a second senior creditor. A note that accrues interest and waits, due after the senior loan, looks much closer to equity. The terms, more than the size, decide which one the lender sees.
How each lands in the senior lender's math
Most senior lenders count both a seller note and mezzanine in total leverage. The difference is in coverage, because coverage tests count only what is paid in cash. Continue the example: the business has cash flow available for debt service of 1,500 a year, and the senior loan's payments are 1,000. Conventional bank lenders commonly look for debt service coverage of at least 1.25x.
| Structure | Annual debt service | Cash flow needed at 1.25x | Cash flow available |
|---|---|---|---|
| Senior loan plus seller note on full standby | 1,000 | 1,250 | 1,500 |
| Senior loan plus seller note paying interest of 90 | 1,090 | About 1,360 | 1,500 |
| Senior loan plus mezzanine paying cash interest of 170 | 1,170 | About 1,460 | 1,500 |
The standby note leaves the most room, which is why many senior lenders ask for one. A paying seller note costs a little coverage. Mezzanine costs the most, and its cushion here is thin: a modest dip in earnings would push the combined coverage below where the bank is comfortable, and the mezzanine lender has its own covenant set behind the bank's. PIK interest does not count in coverage, so a mezzanine lender willing to take more of its return as PIK eases the test, at the cost of a growing balance. For how coverage is defined, see debt service coverage ratio and DSCR vs FCCR.
Leverage treats the two alike. Coverage does not: every dollar of cash interest to a mezzanine lender comes out of the same cash flow the senior lender is testing.
Using both
The choice is often not one or the other. A common structure takes as much seller paper as the seller will carry on terms the bank accepts, and fills the rest with mezzanine or more buyer equity. The order of priority is usually senior lender first, mezzanine second and the seller last, with an intercreditor agreement between the lenders and a subordination agreement binding the seller. Three creditors mean three sets of interests to reconcile, and the seller, as the least experienced party, needs the terms explained early.
Mezzanine lenders also have minimum sizes. A gap too small to interest a mezzanine fund may be better filled with a larger seller note, more equity, or a stretch senior loan that covers more of the price with one lender. If the choice is between junior debt and giving up equity, see mezzanine vs preferred equity.
Which one fits
A larger seller note usually fits when the seller is willing and can live with deep subordination, the gap is modest, or coverage is tight enough that every dollar of cash interest matters. Mezzanine usually fits when the gap is larger than any seller would carry, the seller needs cash at closing, the business's cash flow comfortably covers the added interest, and the buyer values a lender that can also fund later growth.
Either way, the senior lender will want to see the whole structure at once: sources and uses, the note's or the mezzanine's terms, and coverage and leverage after all of it. Midas Partners's financing model shows each structure side by side, and the lender book holds 1,148 lenders writing term and private credit, mezzanine funds and SBICs among them. Once the documents are in, including the target's latest full year of figures and the letter of intent, Midas Partners builds the full lender package in a day, and a senior banker checks every page before the buyer approves it. See what goes in the package and what lenders need to finance an acquisition.
Common questions
- Is a seller note cheaper than mezzanine debt?
- Usually. Sellers price the note as part of getting their price, rarely ask for warrants, and often accept interest-only terms. Mezzanine carries a fund's return target, often warrants and prepayment premiums. But a larger note can come with a higher headline price, so compare total consideration.
- Will a senior lender count a seller note as debt?
- In leverage, most do. In coverage, only the payments count, so a note on full standby may be left out of the coverage test, and some lenders will credit a deeply subordinated, non-paying note toward the equity cushion. A note that pays currently is treated as debt service.
- Can I use both a seller note and mezzanine?
- Yes. The usual order is senior lender, then mezzanine, then the seller, with an intercreditor agreement between the lenders and a subordination agreement binding the seller.
- Why would a seller refuse a larger note?
- Because it is a subordinated, often unsecured loan to a buyer they barely know, and the senior lender will block payments if things go wrong. Many sellers want cash at closing, especially if they are retiring.
- How small a gap will a mezzanine fund fill?
- Mezzanine funds set minimum deal sizes, and a gap below a fund's minimum will not interest it however good the company. Small gaps are usually filled with a larger seller note, more equity, or a stretch senior or unitranche loan that covers more of the price with one lender.
- Does PIK interest help with coverage?
- Yes, because coverage counts only cash paid. Taking more of the mezzanine return as PIK eases the senior lender's test, but the balance grows and must be repaid or refinanced at maturity.