Seller notes and standby paper

Anchored to
Median bank debt of $673,000 rarely funds the whole price

Why the gap exists

The median SBA-financed acquisition in the file carries $673,000 of bank debt. That is the loan, not the price. A buyer must put in equity of their own, and the bank sizes its loan against what the earnings will service, not against what the seller hopes to receive.

When the price the parties want sits above bank debt plus buyer equity, one of three things happens: the price comes down, the deal dies, or the seller finances the difference. The third is a seller note, and it is common enough that a seller should decide their position on it before it is proposed rather than during a negotiation.

Standby, and what it costs the seller

Where a bank is involved, it will not accept a second lender competing for the same cash flow. So the seller note is placed on standby: subordinated to the bank, and typically barred from receiving payments for a defined period, sometimes interest only, sometimes nothing at all.

Sellers consistently underestimate what this means. A note on full standby is not a payment plan. For its standby period it is a promise that ranks behind a bank with security over everything, from a business the seller no longer controls. If the business fails during that window, the note is usually worth nothing. The compensating advantage is that a standby note can be what makes the whole structure work, and without it the price would have been lower or there would have been no deal.

The terms that matter

The standby period and what happens after it. The seller should know exactly when payments start, whether interest accrues during standby or is forgiven, and what triggers a return to normal payment.

The rate. Seller paper is riskier than bank paper and should not be priced as though it is not. A note at a token rate is a price reduction described as a financing.

Security, to the extent permitted. Behind the bank there may still be room for a second charge, a personal guarantee from the buyer, or a pledge of the shares so the business returns to the seller on a default. What is available depends on what the senior lender allows, and asking early is the only way to find out.

Default and acceleration. What counts as a default, what notice is required, and what the seller can actually do. A remedy that cannot be exercised until the bank is repaid is worth knowing about in advance.

Set-off. Buyers often want the right to reduce note payments against warranty claims. That converts the note into an informal escrow with no cap and no referee. It should be resisted, or at least bounded, and it interacts directly with the indemnity provisions.

The risk being taken

A seller carrying paper has sold the business and kept the credit risk. They no longer run the company, no longer see the management accounts unless the note says so, and cannot influence the decisions that determine repayment. The buyer may be competent. They may also be a first-time operator whose only experience of the industry is the diligence they just completed.

Information rights are the cheapest protection available and the most frequently forgotten. A note that entitles the holder to periodic financial statements gives a seller early warning; a note that does not means the first sign of trouble is a missed payment.

Judging whether to do it

The question is not whether a seller note is good or bad. It is whether the deferred portion is money the seller can genuinely afford to lose, and whether the extra price it unlocks compensates for the risk of losing it.

A useful discipline is to value the deal twice: once at the cash actually received at closing, and once at the headline. If the cash-only number is acceptable, the note is upside. If the deal only works at the headline, the seller has not sold the business so much as swapped ownership for an unsecured position in it.