Understanding Seller Note Subordination in Business Acquisitions
Understanding Seller Note Subordination in Business Acquisitions
When you engage in a business purchase or acquisition and you are getting a bank loan and there is a seller note, there's a crucial legal document that your bank may require - a seller note subordination letter. This document establishes the payment hierarchy between two types of debt that arise in such transactions: The "Senior Debt" and the "Seller Note".
Senior Debt: This is the main loan provided by the bank for the acquisition. When it comes to repayment and default scenario, the Senior Debt takes precedence. It essentially holds the strongest claim on your assets if a default occurs.
Seller Note: The Seller Note is a form of debt given out by the seller to you, the buyer. Rather than making an upfront full payment for the purchase, you agree to repay the seller in installments, with interest over a predetermined period.
The subordination letter makes it clear that the Seller Note is "subordinate" to the Senior Debt, implying:
Repayment Order: In case of financial strains, the Senior Debt has to be settled in full before any payments can be directed towards the Seller Note.
Implications of Default: In the event of a default on the Senior Debt, the bank has the right to claim your assets to recoup the outstanding loan amount. However, regular servicing of the Senior Debt leaves the Seller Note untouched.
Security Interest: The bank may use your Seller Note as extra collateral for the Senior Debt, thereby enhancing their claim on your assets in case of a default.
When financing an acquisition, regardless of it being SBA or conventional, the lender will require the subordination of the seller's promissory note. This is required whether the bank finances a majority or a minority of the purchase price.
In our experience while most sellers may not initially be familiar with the subordination requirement they understand why it’s required and do not go into shock. However, some sellers may find this requirement unexpected and perhaps even alarming. especially if they are seller financing 50% or more of the deal. To avoid last-minute surprises, it's best to address the issue of subordination early (but not too early) in the negotiations.
Sellers on the other-hand should aim to minimize seller financing to shift the majority risk to the buyer/lender. If your buyer is a qualified borrower then the lender may not require any of the purchase price to be in a seller note and when they do it is usually between 10% and 25%. It's understandable for a seller financing a substantial part of the acquisition to feel frustrated at having to subordinate their rights to a bank that's assuming less risk. Nevertheless, it's a standard requirement in business banking. It’s also a reason why we don’t see a lot of 50%+seller financed franchise loans as well.