Seller Notes Explained

Most business owners imagine that when they sell their company, they’ll receive the full purchase price in cash at closing. In reality, that almost never happens, especially in the lower middle market (companies valued between roughly $3 million and $50 million in annual revenue).

Buyers frequently structure deals so that a portion of the price is deferred. This not only aligns post-closing incentives between buyer and seller but also makes the acquisition more financially feasible. One of the most common tools used to achieve this is the seller note.

What Is a Seller Note?

A seller note is a loan from the seller to the buyer that covers part of the purchase price. In effect, the seller acts as the bank for that portion of the transaction. The buyer repays the seller over time, with interest.

In lower middle market business sales, seller notes generally represent 5% to 30% of the total purchase price. Note terms are usually from four to eight years, with interest rates slightly above or below market lending rates. For many transactions, the seller note bridges the gap between what the buyer can finance through bank debt and the seller’s price expectations.

Why Buyers Use Seller Notes

Buyers include seller notes in deal structures for two key reasons:

1. Alignment of Interests:

Keeping the seller financially invested in the company’s success after the sale encourages continued cooperation, a smoother transition, customer retention, and stable operations. Even if the seller leaves the business a year or two after the sale, a seller note gives the seller a financial stake in the company’s continued success.

2. Financing Flexibility:

A seller note reduces the buyer’s immediate cash requirement and makes it easier to secure bank financing. Banks often view seller financing as a sign that the seller has confidence in the business’s future performance.

Typical Terms and Payment Structures

Seller notes are flexible by design. Banks cap how much senior debt a deal can carry and they require a minimum debt-service coverage ratio (DSCR). If the company’s projected cash flow is tight in the first 12 - 24 months after the sale due to integration costs, seasonality, or working-capital needs, buyers (or their bank) will often propose special terms that reduce cash out the door in the early years while still paying the seller a fair return over the life of the note.

Seller note modifications that ease early-year cash flow;

1. Accrued Interest

For an initial period, interest accrues to the note balance, but no cash payments are made.

2. Interest-Only (IO) Periods

For 6 - 24 months, the buyer pays interest only, with principal payments beginning later.

3. Step-Up (Tiered) Rates

Interest rates may be reduced in early years and then rise throughout the term of the note. For example, interest may be 6% in year one, 8% in year two, and 10% thereafter. This both preserves early cash and encourages the buyer to refinance the seller note in the later years as interest rates increase above market rates.

When bank leverage limits and early-year cash needs collide, the seller note becomes a pressure-relief valve. Well-structured interest-only periods or interest rate step-ups preserve stability in the early years, keeping the bank comfortable, while providing sellers with a fair return.

Seller Note Subordination

Banks require the seller note to be subordinated to bank debt and they may restrict or sequence payments to the seller to make sure they (the banks) get paid if the business is struggling. Banks may protect their first position on debt repayment by tying seller note payments to objective triggers (Debt Service Coverage Ratios, no default, revolving loan capacity, etc.).

Quick seller note example:

Term: 6 years

Years 1–2: Interest-only at 6%

Year 3: Interest rate increases to 8%;

Years 4–6: Interest rate increases to 10%;

Senior lender guardrails: Seller note payments are suspended while the business is out of established senior lender covenants (interest will continue to accrue).

Prevalence of Seller Notes by Deal Size

Seller notes are most common in deals under $10 million, where buyers (often individuals or small investment groups) rely on creative financing to complete the acquisition. As deal sizes grow, banks and other lenders are willing to lend more aggressively, and buyers tend to have more equity to invest. Other deferred compensation techniques such as earnouts and rollover equity also come into play.

SBA Financing & Full-Standby Seller Notes

Seller notes behave differently when the buyer secures financing through the Small Business Administration (SBA) 7(a) program. The SBA provides acquisition financing of up to $5 million through this program. 7(a) financing may be combined with SBA 504 financing for real estate and long-term assets. It may also be combined with other sources of debt on larger transactions.

The SBA 7(a) program allows the buyer to use seller notes as part of the buyer’s equity investment, but only if they meet strict standby (a period of no payments) requirements. As of June 1, 2025, the rules (SOP 50 10 8) around seller notes used as buyer equity were tightened significantly.

What changed in 2025

1. Effective June 1, 2025, SBA updated its rules and equity-injection framework for 7(a) loans that are used for business acquisitions. The key changes are:

2. A 10% minimum equity injection is required for change in ownership transactions.

3. Seller notes can count toward that equity only if they are on full standby for the entire SBA loan term (i.e., no principal or interest may be paid until the SBA loan is fully repaid). This replaces the pre-2025 two-year standby requirement.

4. A seller note used as equity cannot exceed 50% of the required equity injection. Because the equity minimum is generally 10%, at least 5% must be true buyer cash. The remaining 5% can be a full-standby seller note.

Many SBA-backed transactions feature two separate seller notes—one on full standby to meet buyer equity requirements (up to 5% of deal value) and a second note with more traditional repayment terms.

SBA 7(a) Seller Note Example

Purchase price: $8,000,000

Equity requirement (10%): $800,000

Buyer cash: $400,000 (must be at least 5% of purchase price)

Seller Note A (equity-counting): $400,000 on full standby for entire SBA term (typically 10 years)

Senior SBA 7(a) loan + other debt: $6,000,000

Seller Note B (repayable): $1,200,000 (subordinated and may include a stepped interest rate and/or an interest-only period)

Risk and Security Considerations

Because seller notes are subordinate to bank debt and almost always unsecured by collateral, they carry inherent risk for the seller. If the buyer defaults, the seller may recover little or nothing. In some cases, especially when the buyer is an individual, the seller can request a personal guarantee, though the value of that guarantee depends entirely on the buyer’s personal net worth.

Despite these risks, seller notes are generally less contentious and less dependent on post-sale performance metrics than earnouts, making them a simpler, cleaner mechanism for deferred payments.

Market Trends

Seller note terms fluctuate with credit markets. When banks tighten lending standards and when interest rates are high, more buyers will ask for seller notes. According to recent middle-market transaction data (GF Data, Q2 2024), the average seller note share increased from about 8% in 2021 to nearly 12% in 2024 for sub-$25 million transactions, reflecting both a tougher lending environment and sellers’ willingness to facilitate deals.

Conclusion

Seller notes have become a defining feature of small and mid-sized M&A transactions. While they do introduce some post-closing risk, they also expand the pool of qualified buyers, help transactions close faster, and can even yield favorable returns for the seller.

Understanding how seller notes work allows business owners to enter their sale process with realistic expectations and negotiate with confidence.

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About Venture 7 Advisors:

Venture 7 Advisors is a team of merger and acquisition advisors who assist the owners of small and mid-sized companies to plan and complete the sale of their business. We find the best buyer to meet each business owner’s financial and legacy goals. We represent clients in consumer products, distribution, manufacturing, B2B services, construction, telecommunications, and eCommerce from offices in Burlington, Vermont, the Hudson Valley, New York, and Western Massachusetts.    

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Bryan Ducharme

Managing Partner

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