In a conventional deal, senior lenders generally accept a seller note that is subordinated to them by written agreement, unsecured or on a junior lien, and matures after the senior loan. Interest can usually be paid in cash while there is no senior default. Principal before the senior loan is repaid is allowed only if the company passes the senior covenants after the payment, or not at all. Structured that way the note counts as junior capital: it sits outside senior leverage, adds little to debt service, and lets the buyer put in less cash.
- Rate
- Negotiated with the seller; cash interest allowed while no senior default exists
- Principal
- Bullet after the senior loan, or payments conditioned on covenant tests
- Maturity
- After the senior loan matures
- Security
- Unsecured, or a junior lien subordinated by agreement
- Blockage
- All payments stop during a senior payment default, and usually during any other senior default
- Counts in
- Total leverage and debt service, not senior leverage
Why the rules are different outside SBA
On an SBA loan, the seller note's terms are largely set by the program. A note can count for up to half of the required equity injection only if it is on full standby, with no principal or interest paid, for the life of the SBA loan. A note that is not on standby is allowed, but it counts in debt service like any other loan. Seller notes and SBA's standby rule covers that in full.
A conventional senior lender, whether a bank or a private credit fund, has no program rule to point to. It decides what it will accept, and the answer depends on how much it is lending, how strong the coverage is and how much it trusts the buyer. That gives the buyer room to design a note that suits the seller as well as the lender. It also means a note can be negotiated into a shape that quietly breaks the senior loan's covenants, which is the mistake this page is about avoiding.
The senior lender does not mind the seller being owed money. It minds the seller being paid before it is, or being able to act before it can.
The terms, one by one
| Term | What senior lenders usually accept | What makes them push back |
|---|---|---|
| Interest rate | A fixed rate agreed with the seller, paid in cash while there is no senior default, or accrued | Cash interest that must be paid whatever the state of the senior loan |
| Principal | A single payment after the senior loan matures, or scheduled payments allowed only if the company passes the senior covenants after each one | Fixed amortization during the senior term with no conditions attached |
| Maturity | After the senior loan's maturity, usually with some margin | A balloon that falls due while the senior loan is still outstanding |
| Security | None, or a junior lien subordinated to the senior lender's | A lien equal to the senior lender's, or a pledge of the shares the senior lender needs |
| Remedies | A standstill: no acceleration or enforcement while senior debt is outstanding, or for a long set period | A right to accelerate or take the business back on a missed payment |
| Offset | The buyer may reduce note payments by indemnity claims against the seller | Nothing; most senior lenders welcome an offset right |
| Amendments | No increase in rate or principal, and no earlier maturity, without senior consent | Freedom for buyer and seller to reprice the note later |
The rate is a commercial question between buyer and seller. Sellers often accept less than a mezzanine lender would charge, because the note is part of getting their price and closing the sale, not a return target for a fund. Senior lenders care more about the timing of cash than the level of the rate: a higher rate that accrues until the senior loan is repaid can be easier to approve than a lower one paid in cash every month.
Amortization and maturity: inside or outside the senior loan
The cleanest note, from the senior lender's side, pays interest only and repays principal in one payment after the senior loan matures. The senior lender is repaid first in full, and the note never competes with it for cash.
Sellers often want principal sooner. There are three common compromises:
- Conditioned amortization. Scheduled principal is allowed only if, after the payment, the company still meets the senior coverage and leverage covenants with some cushion, and no default exists. If the test fails, the payment is deferred, not forgiven.
- Payments from excess cash. Principal is paid only out of cash left after senior debt service and any excess cash flow sweep the senior lender takes.
- A later start. Interest only for the first years, then amortization once the senior loan has paid down, still conditioned on the covenants.
What senior lenders resist is a note that matures inside the senior loan with a large balloon. When it falls due, the company has to pay a sum the senior lender's cash-flow model never included, usually by refinancing the seller note at the moment the business may not be ready. If the seller insists on an earlier maturity, expect the senior lender to require that the balloon can be paid only on the same covenant conditions, and to reserve the right to block it.
Subordination and the payment-blockage triggers
The note will sit under a subordination agreement signed by the seller and the senior lender. It is the seller-note version of an intercreditor agreement, and it is often stricter than the one a mezzanine fund would sign, because sellers do not negotiate these documents for a living.
The blockage triggers senior lenders usually ask for:
- Any senior payment default stops every payment on the note until it is cured.
- Any other senior default, including a missed covenant, stops payments for as long as the default continues, or for a set period after a notice.
- Failure of the pro forma test stops scheduled principal even with no default, as described above.
- Acceleration of the senior loan stops everything, and anything the seller receives afterwards is turned over to the senior lender.
The seller's protection is that blocked amounts are not lost. They accrue, usually with interest, and are paid when the block lifts. A seller who understands that will usually accept the triggers. Subordination terms for seller notes goes further into the document.
How a well-built note reduces the equity check
Senior lenders measure a deal two ways. Senior leverage counts only their own loan against earnings. Total leverage and debt service count every loan, including the seller's. A subordinated note that pays little cash while the senior loan is outstanding adds to total leverage but barely moves coverage, so it can replace buyer cash without making the senior loan riskier.
An example in plain numbers. A business earns 2,000 a year and sells for 10,000. After taxes and maintenance capex it has 1,700 a year available for debt service. The senior lender will lend 5,000, with payments of 1,100 a year, and tests coverage on all scheduled debt payments at 1.25x, a level conventional bank lenders commonly look for. The seller agrees to carry 2,000.
| Structure | Senior loan | Seller note | Buyer's cash | Annual payments tested | Cash flow needed to pass | Passes on 1,700? |
|---|---|---|---|---|---|---|
| No seller note | 5,000 | None | 5,000 | 1,100 | 1,375 | Yes |
| Note paying interest only, principal after the senior loan | 5,000 | 2,000 | 3,000 | 1,100 plus interest of 160 = 1,260 | 1,575 | Yes |
| Note amortizing 400 a year inside the senior term | 5,000 | 2,000 | 3,000 | 1,100 plus 160 plus 400 = 1,660 | 2,075 | No |
The second structure cuts the buyer's cash by two-fifths and still clears the covenant. The third carries the same note but fails, because scheduled principal counts in debt service from the first year. The senior lender would either shrink its loan to make the numbers work, which puts the equity check back up, or decline. The difference between the two is not the size of the note or its rate; it is when principal is paid.
Whether the senior lender will count the note as part of the buyer's own contribution is a separate question. Some conventional lenders treat a deeply subordinated note that pays nothing for an extended period much like equity; others count only the buyer's cash and rollover equity. How much equity you need to buy a business covers what lenders look for.
Earnouts, offsets and what the seller can ask for
Outside SBA, earnouts are allowed; SBA prohibits an earnout to the seller in a change of ownership it finances. A conventional senior lender will usually subordinate an earnout on the same terms as the note, because an earnout payment is still cash leaving the company. Earnout vs seller note compares the two.
Buyers should ask for a right to offset indemnity claims against note payments. If the seller's representations turn out to be wrong, the buyer withholds note payments instead of suing. Senior lenders like offset rights because they keep cash in the company.
Sellers, in turn, can reasonably ask for things a senior lender will usually tolerate: a guarantee of the note by the buyer, subordinated in the same way; a junior lien; acceleration if the business is sold or the senior loan is refinanced; financial reporting; and a step-up in rate while payments are blocked. The senior lender's test for each is simple: does it let the seller be paid, or act, before the senior loan is repaid?
Getting it agreed
Seller notes go wrong most often when buyer and seller agree the terms in the letter of intent and the senior lender sees them only after. Put the note's proposed terms in front of the lender early, with a model that shows the payments against the covenants in each year. Transparent's lender package models the note alongside the senior loan and shows coverage with and without principal payments, so the terms are set to what the lender will accept before the seller is asked to agree. Seller financing vs bank financing and how much seller financing is typical cover the wider choice.
Common questions
- Does a seller note in a conventional deal have to be on standby?
- No. Full standby is an SBA rule. A conventional senior lender can accept current interest and even conditioned principal payments, as long as the note is subordinated and payments stop when the senior loan is in default.
- Can the seller note mature before the senior loan?
- Some lenders allow it, but most resist, because the balloon competes with their own repayment. If it does mature first, expect the payment to be allowed only if the company passes the covenants afterwards.
- Does the seller note count in the lender's debt service coverage?
- Scheduled cash payments on it usually do. That is why an interest-only note with principal deferred until after the senior loan is far easier to fit than an amortizing one.
- Can a seller note be secured?
- Yes, by a junior lien subordinated to the senior lender's. Senior lenders rarely accept a lien equal to their own, or a pledge of the shares they are relying on.
- What happens to the seller note if payments are blocked?
- The blocked amounts are not forgiven. They accrue, usually with interest, and are paid once the senior default is cured or the blocking period ends.
- Will the senior lender treat the seller note as equity?
- Sometimes, if it is deeply subordinated and pays nothing for an extended period. Many lenders still count it in total leverage, so it helps the buyer's cash requirement more than the leverage ratio.