TL;DR: A seller note is a loan from the business seller to the buyer, documented as a promissory note, that bridges the gap between senior debt capacity and purchase price. It's standard in SBA-financed ETA acquisitions, typically covering 10-30% of the deal, and it's subordinated to the bank's position. The seller only gets paid after the senior lender does.
Most ETA buyers can't write a check for the full purchase price. Most bank loans won't cover the entire gap. A seller note fills the difference. According to the SBA 7(a) standard operating procedures for small business acquisitions, a properly structured seller standby note is an acceptable source of equity injection for SBA-financed deals. That makes it one of the most common structural elements in search fund and ETA transactions.
Understanding how seller notes work tells you something important about deal mechanics. It also tells you something about seller psychology. A seller who agrees to carry a note is betting that the business performs after you take over. That alignment matters.
What a Seller Note Is
A seller note, sometimes called a seller carry or purchase money mortgage, is a promissory note signed by the buyer in favor of the seller at closing. The seller effectively lends part of the purchase price to the buyer. The buyer pays that amount back over time with interest.
The note documents: the principal amount, the interest rate, the repayment term, the payment schedule (monthly, quarterly, or deferred), and any subordination terms required by the senior lender.
In most ETA transactions, the seller note is subordinated to senior debt. That means the bank or SBA lender gets repaid before the seller does if the business defaults. The seller takes second position. This is called a subordinated seller note, and it's the structure most lenders require.
How Seller Notes Fit Into the Capital Stack
A typical ETA acquisition has three layers of capital: senior debt, equity, and sometimes a seller note.
Senior debt, usually SBA 7(a) or conventional bank financing, covers the largest share of the purchase price. SBA 7(a) loans can go up to 90% loan-to-value in some cases, but lenders often require the buyer to inject 10-20% equity. A seller note can satisfy part of that equity requirement when structured correctly.
The SBA's standard operating procedures explicitly permit seller standby notes as acceptable equity injection sources. The note must meet SBA specifications: it must be subordinated to the bank's position, and SBA may require that no payments be made on the seller note during a standby period of 24 months or longer after closing. That standby requirement is the seller's real financial commitment. They lend you money and agree not to touch it for two years.
Example structure on a $3M acquisition: $2.1M SBA loan (70%), $450K buyer equity (15%), $450K seller note (15%). The seller receives $2.55M at closing from the bank and buyer equity, then collects the remaining $450K through note payments over 5-7 years.
Typical Terms
Interest rates on seller notes in current market conditions typically fall between 5% and 8% annually, depending on the seller's risk tolerance and how motivated they are to close. Some buyers negotiate rates closer to the prime rate. Others pay more if the seller is reluctant to carry paper.
Terms range from three to ten years, with five to seven years most common. Shorter terms mean higher monthly payments. Longer terms keep cash available for operations and debt service on the senior loan but extend the seller's exposure.
Payment structure varies. Some notes require monthly principal and interest payments. Others defer all payments until the senior lender is satisfied. Balloon notes require interest-only payments throughout the term with a lump sum at maturity. Each structure has tax and cash flow implications for both sides.
The seller note is almost always unsecured or secured by assets subordinated to the bank's collateral position. The seller gets a claim on the business assets only after the bank recovers everything it's owed.
Why Sellers Agree to Carry Notes
From the seller's perspective, carrying a note has three potential benefits and one clear risk.
First, it can close a deal that wouldn't otherwise close. If the buyer can't fully fund the gap between debt capacity and purchase price, a seller note is the bridge. A seller who needs to exit accepts the note or loses the sale.
Second, it generates ongoing income. A seller who receives $450K in note payments over five years at 6% interest earns considerably more than if they had invested that amount in Treasury bills. The interest rate negotiation matters.
Third, it signals confidence. A seller willing to carry a significant note is telling the market that they believe the business will perform. It reduces buyer anxiety about hidden problems. Sophisticated ETA operators sometimes require a seller note precisely for this reason.
The risk is obvious. If the business fails, the seller is last in line. Behind the bank, behind trade creditors, behind anyone with a senior claim. The seller can lose the entire note balance. This is why seller note size as a percentage of purchase price, and the seller's comfort with subordination, varies dramatically by deal.
What Buyers Need to Negotiate
Seller notes are negotiated instruments. The purchase price, note size, interest rate, term, payment schedule, and subordination terms are all variables.
Standby period language matters. If the SBA requires a 24-month standby with no payments, confirm that term explicitly in the note documentation. If the seller doesn't understand they won't receive payments for two years, you'll have a problem at closing.
Subordination agreements require separate documentation. The lender will provide a subordination agreement that the seller must sign, confirming they take second position. This is standard, but sellers sometimes object to the language when they see it for the first time. Surface it early in the due diligence process covered in the acquisition due diligence checklist.
Prepayment rights give you the option to pay off the note early without penalty. Negotiate this upfront. If the business generates cash ahead of projections, you may want to retire the note early to eliminate the ongoing obligation.
Personal guarantee requirements vary. Some sellers request a personal guarantee from the buyer on the note. This creates additional risk for the buyer in a downturn. Whether you accept a personal guarantee depends on how badly you need the note and what alternatives you have.
Tax Treatment for the Seller
A seller note affects the seller's tax timeline. Without a note, the seller receives the full purchase price at closing and pays all applicable taxes in the year of sale. With a note, the sale qualifies as an installment sale under Section 453 of the Internal Revenue Code.
Installment sale treatment allows the seller to recognize gain proportionally as they receive payments over the note term, rather than recognizing the entire gain in the year of sale. For sellers in high income years, spreading gain recognition can reduce total tax paid.
The IRS requires installment sale reporting for sales where at least one payment is received after the year of sale. The gain recognized each year is calculated based on the gross profit percentage: total gain divided by the selling price. Interest received is ordinary income regardless of the installment sale election.
Sellers should model the installment sale election against a lump-sum payment to determine which produces lower total taxes given their income situation, applicable rates, and the time value of deferral. Some sellers opt out of installment sale treatment if they expect tax rates to increase.
Frequently Asked Questions
What percentage of a purchase price can a seller note cover?
In most ETA acquisitions, seller notes cover 5% to 30% of the purchase price. The upper bound depends on the lender's requirements and the seller's willingness to subordinate. For SBA-financed deals, seller notes commonly fill 10% to 20% of the capital stack, with the SBA requiring a standby period before any payments begin.
Does a seller note require interest, and how is the rate set?
Yes, seller notes must include an interest rate to comply with IRS imputed interest rules under Section 1274. If no rate is stated or the rate is below the applicable federal rate, the IRS will impute interest on the note anyway. Typical market rates for seller notes in small business acquisitions range from 5% to 8% annually, negotiated between buyer and seller based on risk, term, and deal dynamics.
What happens to the seller note if the buyer defaults?
If the buyer defaults, the seller's recourse depends on the note terms and subordination agreement. A subordinated seller note means the senior lender (SBA or bank) collects first. The seller can only recover note principal after the senior debt is fully satisfied. In a business failure where senior debt recovery is partial, the seller may recover little or nothing on the note balance. This is the primary risk sellers accept when agreeing to carry paper.
Can a seller note be renegotiated after closing?
Yes, seller notes can be modified after closing by mutual agreement between buyer and seller. Common modifications include extending the term, adjusting the payment schedule, or reducing the interest rate if the business faces temporary cash flow constraints. Any modification should be documented in a note amendment signed by both parties, and the buyer should confirm the modification doesn't trigger any notification requirements under the senior loan agreement.
