Mezzanine debt or a bigger seller note: which should fill the acquisition gap?

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

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 non-SBA deals.

In an SBA deal the rules are fixed. A seller note can count for up to half of the required equity injection only if it is on full standby, with no principal or interest payments, for the life of the SBA loan; interest may accrue and be paid after the SBA loan is repaid. A seller note that is not on standby is allowed, but it is debt: it counts in debt service, not toward the equity injection. And because SBA prohibits an earnout to the seller, the seller note is often the only deferred consideration available. See seller notes and SBA's full-standby rule.

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.

The standby note leaves the most room, which is why many conventional lenders ask for one and why SBA gives it equity credit. 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, coverage is tight enough that every dollar of cash interest matters, or the deal is an SBA acquisition. 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. Transparent's financing model shows each structure side by side, and the lender book holds 1,148 lenders writing term and private credit, credit funds and SBICs among them, and 278 writing SBA 7(a) and 504. Once the documents are in, including the target's latest full year of figures and the letter of intent, Transparent builds the full lender package in a day. See what goes in the package and what lenders need to finance an acquisition.