Key takeaways
- A seller note is subordinated debt, in a default scenario, bank lenders get paid first, leaving the seller exposed on the full note balance.
- Seller notes are most commonly demanded when there is a valuation gap, a thin buyer equity contribution, or a buyer concern about post-close performance.
- The interest rate on a seller note (typically 5–8%) understates the true risk-adjusted cost to the seller because it ignores the subordination and credit risk.
- Negotiate personal guarantees, security interests, and note acceleration provisions before closing, these terms are nearly impossible to improve after the deal is signed.
- A seller note that equals 10–20% of enterprise value is common and manageable. A seller note that equals 30%+ of enterprise value deserves significant scrutiny of the buyer's capitalization and acquisition track record.
When a buyer in a middle market transaction cannot or does not want to pay 100% of the purchase price in cash at closing, they sometimes ask the seller to finance a portion. This seller financing takes the form of a promissory note, typically called a seller note, where the buyer promises to pay the seller the outstanding principal plus interest over a defined period, usually 3–7 years.
Seller notes appeared in approximately 31% of lower-middle-market transactions in 2023, most frequently in PE-backed acquisitions where buyers were maximizing leverage and in smaller transactions below $20M enterprise value where bank financing options were more limited.
The median seller note as a percentage of enterprise value was 12% in 2023 transactions where seller financing was included, typically representing $1.2–2.4M on a $10–20M transaction.
Default or payment disruption on seller notes occurred in approximately 8–11% of transactions where seller notes were included, according to industry advisory data, substantially higher than most sellers anticipate at the time of signing.
A founder sold her $22M revenue professional services firm at a $14M enterprise value. The PE buyer structured the deal as $11M cash at close plus a $3M seller note at 6% interest over 5 years. Eighteen months post-close, the business missed its EBITDA targets due to client attrition that began during the ownership transition. The buyer's senior lender, which had priority on all business assets, went into covenant waiver discussions. The seller note payments were suspended under the subordination agreement. The founder received no note payments for 14 months while the buyer restructured the business. She eventually received partial repayment through a negotiated settlement, recovering approximately $2.1M of her $3M note, with the remainder forgiven as part of a transaction that saved the business from bankruptcy. She had not fully understood the subordination mechanics when she signed.
Seller notes are not inherently problematic. In the right transaction, where the buyer is well-capitalized, the business is stable, and the note is a small percentage of total enterprise value, they are a reasonable bridge for valuation gaps and an efficient financing tool. The risk is in transactions where sellers accept seller note terms without fully understanding the subordination mechanics and the scenarios in which they will not be repaid.
How seller notes are structured: the mechanics
A seller note is a promissory note from the buyer entity to the seller. Its key economic terms are: principal amount, interest rate, payment schedule (interest-only, amortizing, or balloon), maturity date, subordination provisions, and any acceleration or default triggers.
The subordination provision is the most important and least understood term. Subordination means that the bank lender's debt must be fully repaid before the seller receives anything in a default or liquidation scenario. In most middle market transactions, the buyer uses significant bank leverage, often 3–5x EBITDA. If the business underperforms and defaults, the bank will recover most or all of their principal while the seller note may receive partial recovery or nothing.
Typical LMM acquisition capital stack
Senior debt (bank): 45–60% | Equity: 30–45% | Seller note: 10–20%
Seller note payment priority in default
Last, after bank, mezzanine, and any other secured debt
Most common seller note maturity
5 years
Why buyers demand seller notes (and what it really signals)
Buyers ask for seller financing for three distinct reasons, and understanding which one is driving the request tells you a great deal about the transaction quality.
The first reason, and the most acceptable, is a valuation gap bridge. Buyer and seller have a modest difference in enterprise value expectations. The seller note allows the transaction to close at a higher stated price while deferring some of the risk to post-close performance. This is legitimate and common.
The second reason is buyer capitalization constraints. The buyer cannot get enough senior debt or equity to pay 100% at close. This is a more concerning signal, it means the buyer is using the seller as a lender because commercial lenders are not willing to fully finance the acquisition. Sellers should always ask: why is the bank not lending 100% of what the buyer needs?
The third reason, the most concerning, is buyer uncertainty about post-close performance. If a buyer believes the business may underperform post-close, they have a financial incentive to defer as much of the purchase price as possible into instruments (seller notes, earnouts) where payment is conditional or can be disputed. A buyer who immediately pushes for a large seller note and a large earnout may be expressing a lack of confidence in the business's post-close trajectory.
Before accepting a seller note, ask your advisor these three questions: (1) Why can't the buyer get more senior financing? (2) What is the buyer's track record of repaying seller notes in prior acquisitions? (3) What is the pro forma debt service coverage ratio post-close, and what EBITDA decline is required before the business is in covenant default?
Tax treatment of seller notes: the installment sale election
Seller notes create an important tax planning decision: whether to elect installment sale treatment under IRS Section 453, or to recognize the entire gain in the year of sale.
Under installment sale treatment, the seller recognizes gain proportionally as payments are received. This spreads the tax liability over the note's term rather than requiring full payment in the year of closing. For a seller with a large gain, this can provide meaningful cash flow timing benefits, the tax bill tracks the receipt of proceeds.
However, installment sale treatment has risks. If tax rates increase between the closing year and the payment years, the deferred gain will be taxed at higher rates. For sellers with large gains who expect rising tax rates, or who expect a change in capital gains treatment, recognizing all income in the closing year (by electing out of installment treatment) may produce better after-tax results.
Consult a tax advisor before signing the purchase agreement. The installment sale election must be made on the tax return for the year of sale. Reversing the election after the return is filed is extremely difficult. This is a decision that must be made deliberately before closing, not discovered during return preparation.
Negotiating seller note terms: what matters most
The three seller note terms that matter most in a default scenario, and therefore deserve the most negotiation attention, are the acceleration triggers, the security interest, and the cross-default provisions.
Acceleration triggers determine when the full note balance becomes immediately due. Standard acceleration triggers include buyer bankruptcy or insolvency. Sellers should also push for: (1) business sale or change of control, ensures that if the buyer sells the business, the seller note is repaid from the proceeds before the new buyer acquires a debt-free business; (2) material covenant breach under the senior facility, allows the seller to demand repayment if the business is already in financial distress before formal default.
Security interests give the seller a legal claim on business assets if the note is not repaid. Senior lenders will almost always require that any seller security interest be subordinated to theirs, but a second-lien security interest is still far better than an unsecured note. In a liquidation scenario, second-lien holders recover something from asset proceeds; unsecured creditors are among the last in line.
Cross-default provisions tie the seller note to the senior facility, if the buyer defaults on the bank loan, the seller note is also in default, giving the seller the right to accelerate. Without a cross-default provision, the buyer could be in bank default while still technically current on the seller note, leaving the seller with no remedies while the business deteriorates.
Frequently asked questions
What happens if the buyer doesn't pay the seller note?
The seller can accelerate the note (declare the full balance due) if there is an acceleration trigger. If the note is secured, the seller can seek to foreclose on the collateral. If the note is unsecured and subordinated, the seller's options are limited to pursuing legal judgment while senior lenders have priority on business assets. The practical reality is that collecting a defaulted seller note is expensive and often results in partial recovery at best.
Is a seller note the same as an earnout?
No. A seller note is a fixed obligation, the buyer owes a defined principal amount plus interest regardless of business performance, subject to any subordination provisions. An earnout is contingent, the buyer pays only if the business achieves defined performance metrics. Seller notes are safer than earnouts from a collection standpoint (fixed obligation) but still subordinated to senior debt.
How common are seller notes in PE acquisitions?
Seller notes appear in approximately 25–35% of PE-backed lower-middle-market transactions, more commonly in smaller deals (under $20M EV) and in transactions where the buyer is using higher leverage. Strategic acquirers use seller notes less frequently because they typically have stronger balance sheets and access to cheaper capital.
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Seller note terms can significantly affect your net proceeds and post-close risk. We help founders evaluate and negotiate the structure before the LOI.
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