Seller notes can be a useful tool in acquisition financing, but they're also a common source of confusion for buyers and sellers.
Both parties may agree to terms in the LOI, only to find out later that the structure doesn't meet the lender's requirements. Understanding how seller notes work, particularly the standby requirements, can help avoid problems as the deal moves toward closing.
What Is a Seller Note?
A seller note is a loan provided by the seller to the buyer to help finance the acquisition. It covers the difference between the buyer's equity injection, the primary lender's financing, and the total purchase price.
For example:
- Purchase price: $2,000,000
- SBA 7(a) loan: $1,650,000
- Buyer equity injection: $250,000
- Seller note: $100,000
Full Standby vs. Partial Standby
One of the most important considerations when structuring a seller note is whether it will be on full or partial standby.
Full standby means the seller cannot receive principal or interest payments for the entire term of the SBA loan, which is typically 10 years. The seller receives repayment at the end of that period rather than through regular payments.
Partial standby allows the seller to receive interest-only payments during a deferral period, usually 24 months, followed by principal and interest payments.
Why This Matters
The SBA requires buyers to contribute at least 10% of the total project cost as an equity injection.
A seller note on full standby can count toward that requirement, while a note on partial standby cannot.
This distinction has a direct impact on how much cash the buyer needs to contribute.
If the seller note is on partial standby, the buyer must provide the full 10% equity injection in cash. If the note is on full standby, it can cover up to 5% of the required injection, leaving the buyer responsible for the remaining 5% in cash.
When Sellers Will Accept Full Standby
Full standby can be difficult to negotiate because the seller is agreeing to finance part of the acquisition without receiving payments for 10 years.
However, some sellers may be willing to accept these terms when:
- They're motivated to close the transaction and the buyer has limited cash available.
- They have confidence in the buyer's ability to operate the business successfully.
- The seller note represents a relatively small portion of the purchase price.
- The interest rate provides enough compensation for the risk of delayed repayment.
Many sellers prefer partial standby because it allows them to begin receiving payments sooner.
If the seller insists on partial standby, the buyer will need to provide the full 10% equity injection in cash. That additional cash requirement needs to be factored into the acquisition structure.
Structuring the Interest Rate
SBA guidelines place limits on the interest rates that can be charged on full-standby seller notes. These limits are typically tied to the prime rate, so it's important to review the current SBA SOP before agreeing to terms.
Interest rates on partial-standby notes are negotiable.
Sellers often seek rates around prime plus 2–3%, while buyers generally want to keep borrowing costs as low as possible. In the current rate environment, a practical range is approximately 6–9%.
Tax Considerations for Sellers
Seller notes may offer tax benefits through installment sale treatment, assuming the seller elects this approach.
Rather than recognizing the entire gain in the year of the sale, the seller can spread gain recognition over the repayment period.
For sellers facing significant capital gains, this can be an appealing part of the transaction.
Buyers can use this potential tax benefit during negotiations. Depending on the seller's circumstances, receiving part of the purchase price through a seller note may offer a more favorable after-tax outcome than receiving the same amount in cash at closing.
What to Include in the LOI
Seller note terms should be clearly outlined in the LOI to avoid confusion later in the financing process.
Simply stating that the seller will carry a $200,000 note leaves several important details unresolved.
Instead, specify the note amount, interest rate, standby requirements, and repayment terms.
For example:
"Seller will carry a $200,000 subordinated promissory note at 7% interest, on full standby for the term of the SBA loan, with all principal and interest due at maturity."
Getting these terms agreed upon early can help prevent weeks of renegotiation once the lender begins reviewing the deal.