Seller Note Security

December 01, 2023

by a searcher from The University of Chicago - Booth School of Business in Chicago, IL, USA

I am negotiating an LOI and the broker is insisting it is market practice to secure seller notes. I do not believe this true but would love any resources to support my perspective:

Does anyone know what percent of loans have an unsecured vs secured seller note? Or any other resources that might answer this question?

***Update to original post: My specific question is: what have people seen when it comes to a Personal Guarantee from the buyer on the seller note? For context, sub 3M deal with a 10% seller note.

Definitely looking for outside resources if possible too!

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Reply by a professional
from University of Toronto in Toronto, ON, Canada

^redacted‌, there are multiple possible answers to your question. Fundamentally, a seller's note is normally 'junior' or 'subordinate' debt relative to the mainline lender, usually a bank, which has senior position. But the junior/senior ranking issue doesn't determine whether the seller's note is secured or not and, if so, in what manner, The security issue relates to risk mitigation by the seller, which typically is a function of the term of the note (the time duration of the seller's exposure) - the longer the seller's exposure, the greater their desire for security. The nature of the security is determined both by buyer/seller negotiation and the influence of third parties: a personal guarantee by the buyer may be requested if the seller has longer-term exposure that means repayments is more heavily dependent on the buyer's successful management of the business; and the seller may also request a lien on the company's assets, but that would inevitably be subordinated to the mainline lender which has senior secured position. You will also need to consider the impact of securing a seller's note on the availability of senior financing: some banks will allow seller notes to be considered as part of the equity in the deal, but sometimes that won't work if the notes are secured (even if they are subordinated) so security may jeopardize the overall deal structure.

Reply by a searcher
from United States Naval Academy in Philadelphia, PA, USA

As you can probably see from the answers above, context matters in answering this question. If you're buying a $10m+ EV company then yes, it will probably be secured against the assets of the company in a 2nd lien position and you won't be required to sign a personal guarantee.

If you're dealing with a small company in the $0 - $5m range then absolutely not. The reason is simple - you're relying on the seller's reps (both contractual and verbal) in buying the business. Giving them a secured position means if anything goes wrong and you default on their note, they can foreclose on the business and effectively take the business back while also walking away with what you paid. Unlikely scenario? Yes. But why risk it? That's what an earnout or personal guarantee is for. There's a whole host of other reasons not to give them a secured position in this scenario and I'm happy to discuss elsewhere.

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