Understanding Seller Note Subordination in Business Acquisitions
Understanding Seller Note Subordination in Business Acquisitions
If you're considering purchasing a business and planning to secure a bank loan, there's an essential legal document you should be aware of: the seller note subordination letter. This document clarifies the payment hierarchy between two types of debt you might encounter: "Senior Debt" and "Seller Note."
Senior Debt: This is the primary loan provided by the bank to finance your acquisition. In terms of repayment, Senior Debt takes precedence—holding the strongest claim on your assets should a default occur.
Seller Note: This is a type of debt issued by the seller to you, the buyer. Instead of paying the full purchase price upfront, you agree to make installment payments to the seller, typically with interest, over a set period.
The subordination letter clearly states that the Seller Note is "subordinate" to the Senior Debt, which means:
Repayment Order: If financial difficulties arise, you'll need to pay off the Senior Debt in full before directing any payments toward the Seller Note.
Implications of Default: If you default on the Senior Debt, the bank can claim your assets to recover the outstanding loan amount. However, as long as you're servicing the Senior Debt, the Seller Note remains unaffected.
Security Interest: The bank might also use your Seller Note as additional collateral for the Senior Debt, strengthening their claim on your assets if you default.
When financing an acquisition—be it through SBA loans or conventional financing—lenders will typically require the seller's promissory note to be subordinated. This applies regardless of whether the bank is funding a majority or minority of the purchase price.
From our experience, while many sellers might not be familiar with the subordination requirement at first, they generally understand its necessity and don’t react negatively. However, some sellers may find this requirement surprising, particularly if they're financing a significant portion of the deal. To prevent any last-minute surprises, it’s wise to discuss the issue of subordination early in the negotiations.
For sellers, minimizing seller financing can help shift the majority of the risk onto the buyer or lender. If your buyer is a qualified borrower, the lender might not require any seller financing, and when they do, it usually ranges from 10% to 25%. It’s natural for sellers financing a large part of the acquisition to feel frustrated about subordinating their rights to a bank taking on less risk. Yet, this is a standard practice in business acquisitions. This explains why we often see fewer franchise loans with 50% or more seller financing.
This article is authored by Darin Manis, founder of LoanBox.