A note on full standby receives no payments at all, neither principal nor interest, until the senior lender allows them: usually once the senior loan is repaid, or once tests written into the subordination agreement are met. Lenders ask for it on seller notes in acquisitions and on loans owners or shareholders have made to the company. Because the note pays nothing, the lender leaves it out of debt service and treats it as closer to equity than debt. The holder takes the risk and the wait; interest usually accrues and is paid later.
- Meaning
- No principal and no interest paid while the standby lasts
- Who is asked for it
- Sellers taking back a note; owners and shareholders who have lent to the company
- How long
- Until the senior loan is repaid, or until release tests in the subordination agreement are met
- Effect on coverage
- Left out of debt service while nothing is paid
- Documented by
- A subordination or standby agreement between the holder and the senior lender
What full standby means
Standby is a creditor's promise to wait. Full standby is the strictest form: the note receives no payments of any kind while the standby lasts. Not principal, not interest, not a reduced amount. Arrangements that allow interest, or pay the note while the company meets its covenants, are subordination on softer terms, not full standby.
The holder signs the promise in a subordination agreement with the senior lender. In it the holder agrees that the note ranks behind the senior loan, that no payment will be made or accepted until the agreement allows it, that the holder will not sue, accelerate or enforce any lien while the senior loan is outstanding, and that anything received by mistake is turned over to the senior lender. The note itself must say the same thing; a note whose terms conflict with the subordination agreement is a problem the lender's counsel will find before closing.
Interest usually keeps accruing during standby, often at a rate that reflects the wait, and is paid when the standby ends. What is deferred is the cash, not necessarily the return.
Where lenders ask for it
A senior lender almost always requires junior notes held by insiders or sellers to be subordinated. It asks for full standby, rather than lighter terms, when the company's cash flow leaves little room for anyone but the senior lender.
| Situation | What the senior lender usually asks | Why |
|---|---|---|
| Seller note in an acquisition | Subordination; full standby when coverage is tight or the senior loan is stretched | Keeps cash for the senior loan in the early years, and keeps the seller invested in the result |
| Loans from owners or shareholders already on the books | Subordination, often full standby; sometimes conversion to equity | The lender will not have owners repaid ahead of it |
| A refinancing or recapitalization with an existing junior note | Payoff at closing, or standby | A junior note paid currently competes with the senior loan for the same cash |
Owners who have seen standby written as a fixed rule in SBA lending should know that at this size it is a negotiated term. A company with $10M to $100M+ in revenue has usually outgrown the 7(a) program's $5 million cap, and its bank or private credit lender sets standby terms deal by deal. See seller note terms in conventional deals and how lenders treat shareholder loans.
How standby changes the lender's arithmetic
A note that pays nothing takes nothing from the cash flow the senior lender is counting on. In the debt service coverage or fixed charge coverage test, its payments simply are not there. On a tight deal, moving a seller note from paid to full standby can be the difference between coverage the lender accepts and coverage it does not.
| Line | Seller note paid currently | Seller note on full standby |
|---|---|---|
| Cash flow available for debt service | 1,500 | 1,500 |
| Senior loan payments | 1,000 | 1,000 |
| Seller note payments | 250 | 0 |
| Total debt service | 1,250 | 1,000 |
| Cash flow against debt service | 1,500 against 1,250 | 1,500 against 1,000 |
Leverage is a separate question. Whether a standby note counts in the leverage covenants depends on how the credit agreement defines funded debt: some definitions leave out a note on full standby, others count it in total leverage but not in senior leverage. In sizing an acquisition, lenders also look at how much of the price is funded by cash equity. A note that cannot be paid behaves more like equity than debt while it waits, and some lenders give it partial credit toward the buyer's contribution; a paid note is debt.
Standby helps coverage only while it lasts. Model the year the note starts paying, not just the year the deal closes.
Full standby and softer subordination terms
| Term | Payments to the holder | When payments stop |
|---|---|---|
| Full standby | None until the senior loan is repaid or release tests are met | Never start during the standby |
| Payment blockage | Scheduled payments allowed | On a senior default or covenant breach, until cured or for a set blockage period |
| Payments subject to a test | Allowed if leverage or coverage after the payment stays within a stated level | Whenever the test would be failed |
| Interest only, principal deferred | Interest paid; principal due after the senior loan | On a senior default, under the blockage terms |
Conventional lenders often let a seller be paid currently if coverage and leverage leave room, with a blockage on default. Full standby tends to appear when the senior loan is sized close to the lender's limit, when the seller note is large relative to the equity, or when the note is owed to insiders the lender does not want paid first. See seller note subordination terms.
What the holder gives up, and gets
- Time. No cash until the senior loan is repaid or the release tests are met.
- Priority. If the company fails, the senior lender is repaid from the collateral first, and the holder may receive nothing.
- Remedies. The holder cannot enforce the note while the senior loan is outstanding, even if the company misses its own promises on it.
- Liquidity. A note on standby is hard to sell or borrow against.
In return, a seller gets a closed sale at the agreed price, which may not have happened otherwise, and usually better terms on the note itself: a higher accruing rate, a balloon when the standby ends, or an agreed test, such as a leverage level, at which the note switches to current payments. A later refinancing can end the standby too, though the new senior lender will usually want the note subordinated on its own terms; see refinancing a seller note. Sellers should take tax advice, since the timing of payments on an installment sale affects their taxes.
Negotiating it
The terms of a seller note belong in the letter of intent, not in the last week before closing. A seller who agreed to monthly payments and learns at closing that the note must sit on full standby is a deal at risk. The points to settle early are whether the note is paid, blocked on default or on full standby; the release tests that end a standby; how interest accrues and when it is paid; and a maturity that falls after the senior loan's, which senior lenders generally require.
Senior lenders differ on all of these. In Midas Partners's process lenders that fit see a blind teaser first, and the client approves each lender by name before it learns who the client is, so the proposed note terms can be tested against several lenders' requirements while the seller is still at the table. See how much seller financing lenders accept.
Common questions
- What is the difference between standby and full standby?
- Full standby means no payments at all, principal or interest, until the senior lender allows them. Other standby or subordination terms let some payments through, such as interest only, or scheduled payments that stop only if the company defaults on the senior loan.
- Can interest accrue on a note on full standby?
- Yes. Interest usually accrues during standby and is paid when it ends. What may not happen is any payment, principal or interest, while the standby lasts.
- Does a note on full standby count in debt service coverage?
- No. Because it receives no payments, it is left out of debt service. A paid note's payments are included. Whether it counts in leverage depends on the credit agreement's definitions.
- When does full standby end?
- When the subordination agreement says it does: usually when the senior loan is repaid, or when the company meets release tests such as a leverage or coverage level. A refinancing can also end it, subject to the new lender's terms.
- Can the company pay the seller early if the business does well?
- Only with the senior lender's consent or once the release tests are met. A payment made in breach of the subordination agreement is a default under the senior loan, and the holder usually has to turn the money over to the senior lender.