Introduction
The owner of a commercial HVAC maintenance company agrees to sell for $20 million, five times its $4 million of EBITDA. The buyer's bank will lend $10 million against those cash flows, and the buyer and its investors can raise $6 million of equity. That leaves $4 million of the agreed price unfunded, with closing a month away.
The owner closes the gap by lending it. At closing the buyer pays $16 million in cash and signs a promissory note for the rest: 6% interest, repayable in five years, ranked behind the bank. That arrangement is seller financing, and the instrument is a seller note.
It looks like a footnote, yet it changes most of what matters: how much the bank will lend, what the buyer earns, when the seller pays tax, and what the seller is left holding if the business stumbles. In smaller private deals it is often what turns a price agreement into a closing, so it pays to understand it from both sides of the table: where notes appear, the terms and SBA rules that govern them, the returns math, and the seller's risks.
Seller Notes Versus Earnouts, Rollover and Escrows
Sellers rarely take every dollar at closing, and the tools for deferred consideration look alike from a distance. They differ in what the seller holds afterwards and what must go right for the money to arrive.
| Feature | Seller note | Earnout | Rollover equity | Escrow or holdback |
|---|---|---|---|---|
| What the seller holds | Debt claim on buyer | Contingent price right | Shares in the new owner | Cash held back |
| Amount fixed at closing? | Yes | No | No | Yes, less claims |
| Main job | Fill a financing gap | Bridge a valuation gap | Align, shrink equity check | Secure indemnities |
| Where it ranks | Behind senior debt | Unsecured contract right | Behind all debt | Cash set aside |
An earnout pays more only if the business hits agreed targets, so it settles an argument about the future rather than a shortage of cash. Rollover equity keeps the seller as a shareholder alongside the buyer. An escrow or holdback parks part of the price for a year or two to cover indemnity claims. Only the seller note is a fixed debt obligation: the buyer owes it whether the business beats its plan or misses it, once the senior lenders have been looked after.
What Seller Financing Is
A Loan From the Seller to the Buyer
Seller financing is a deferred purchase price structured as a loan. The seller accepts a promissory note for part of the price, and the buyer repays it over an agreed period with interest. US practice calls it a seller note, seller paper or owner financing; UK and European deals say vendor note or vendor loan note.
The issuer is usually the acquisition vehicle or the acquired company, so the note is repaid from the cash flows the seller used to own, and it almost always ranks behind the senior lender.
- Seller Note
A promissory note issued by the buyer of a business to the seller for part of the purchase price, repaid over time with interest instead of in cash at closing. Also called a vendor note or vendor loan, it is debt of the buyer, usually subordinated to the senior acquisition lenders, and is most common in smaller private sales where bank debt and buyer equity do not cover the full price.
Where Seller Notes Show Up
Seller notes cluster wherever financing is thin relative to the price:
- Lower middle market and owner-operator sales, where banks lend cautiously against founder-dependent businesses.
- Search fund and independent sponsor deals, where a first-time buyer raises equity deal by deal.
- Private equity deals and corporate carve-outs, where a note can bridge a price gap.
- Distressed or hard-to-finance sales, where the choice is between taking paper and not selling.
Notes are rarely the largest piece of a deal. The IBBA and M&A Source Market Pulse survey for the second quarter of 2026, covering sales up to $50 million, found sellers received 83% to 92% of value in cash at close on average, with seller financing under 10% of most deals.
Why Buyers and Sellers Agree to Seller Financing
Filling the Financing Gap
Senior lenders size loans to cash flow coverage, not to the agreed price. A bank comfortable at about 2.5x EBITDA stops at $10 million on the HVAC business, whatever the buyer thinks it is worth. Above that line the buyer needs more equity, which is expensive and may not exist, or mezzanine debt, which typically costs well into double digits.
A seller note is usually the cheapest junior capital on offer. The seller knows the business, has no fund investors to answer to, and will often accept a single-digit rate because the alternative is a lower price or no deal.
Bridging a Valuation Gap and Signaling Confidence
Notes also settle price disputes. A seller anchored on $20 million and a buyer who can fund $16 million in cash can agree on a headline price, with the difference paid over time. Unlike an earnout, the deferred amount does not depend on performance, which suits a seller who trusts the business more than the buyer's accounting.
Willingness to carry paper is also information. A seller who takes a note is betting that the business can service its debt after they leave, and lenders read it that way; a seller who insists on all cash invites questions. The note is a confidence signal as much as a financing tool.
Tax Timing for the Seller
For a US seller, the note changes when tax is due. Under the installment method, a sale with at least one payment after the year of sale is taxed as the cash arrives rather than all at closing, as IRS Publication 537 explains. Each principal payment splits between tax-free return of basis and taxable gain using the gross profit percentage:
Give the HVAC owner a $2 million tax basis in a straightforward stock sale. Gross profit is $18 million on a $20 million contract price, or 90%, so the $16 million received at closing triggers $14.4 million of gain that year and the other $3.6 million is taxed when the note's principal is repaid. Interest on the note is ordinary income.
- Installment Sale
A sale of property in which the seller receives at least one payment after the tax year of the sale. Under US tax rules the seller generally reports gain in proportion to the payments received rather than all at once, using the gross profit percentage, while interest is taxed as ordinary income. It is the default treatment unless the seller elects out.
The deferral has limits:
- Depreciation recapture is taxed in full in the year of sale, so an asset sale of an equipment-heavy business front-loads more tax than the cash split suggests.
- When more than $5 million of installment notes from sales over $150,000 remain outstanding at year end, the IRS charges interest on the deferred tax.
Key Terms of a Seller Note
Size, Rate, Maturity and Repayment
No public dataset tracks seller note terms the way loan databases track bank debt, so the shapes below are illustrative of common smaller-deal practice, not market data.
| Term | Illustrative shape | What pushes it |
|---|---|---|
| Size | Often 10-20% of price | Gap between debt capacity and price |
| Interest rate | Mid-to-high single digits | Seller's leverage, lender limits |
| Maturity | 3-7 years | Senior loan's maturity |
| Repayment | Amortizing or bullet | Lender's cash flow rules |
| Interest form | Cash, PIK or a mix | Buyer's debt service capacity |
| Security | Unsecured or junior lien | Senior lender consent |
The buyer wants a long maturity, a low rate, no amortization and the option to pay interest in kind, keeping cash for the bank; the seller wants the reverse. A bullet repayment concentrates the seller's risk on one date, usually when the buyer must refinance or sell, and PIK interest grows the claim without paying the seller anything until the end.
Subordination and the Intercreditor Terms
The term that matters most is rarely the rate. The bank will require a subordination agreement, sometimes inside a broader intercreditor agreement, that fixes the note where subordinated debt sits in the LBO capital stack: below the senior loans, above the equity.
- Subordination Agreement
A contract between a senior lender and a junior creditor, such as a seller holding a note, under which the junior creditor agrees to be paid only after the senior debt and to limit its own remedies. It typically blocks junior payments while the senior debt is in default, imposes a standstill before the junior creditor can enforce, and requires payments received in breach to be turned over to the senior lender.
The provisions worth reading closely:
- Payment blockage: note payments typically stop for as long as a senior payment default continues, and for a limited period after other defaults.
- Standstill: the seller cannot accelerate, sue or enforce for a set period, or until the bank is repaid.
- Turnover: anything received in breach goes to the senior lender.
Together they turn a fixed promise into a contingent claim whose timing the bank controls.
Deal structure questions reward a clear framework: The 160-page PDF covers M&A, LBO and valuation technicals with the frameworks superday interviewers expect, and place seller financing within the rest of the capital structure.
Seller Notes in SBA 7(a) Acquisitions
Many US small business acquisitions are financed with SBA 7(a) loans, and SBA rules decide how a seller note can be used. Under SBA SOP 50 10 8.1, effective October 1, 2026, a buyer in an initial acquisition must inject at least 10% of total project costs as equity, a minimum that cannot be reduced or waived.
A seller note counts toward that injection only if it is subordinated to the SBA lender and on full standby: no principal or interest payments for the entire term of the 7(a) loan, commonly ten years for a business acquisition without real estate. Even then it is one of the limited equity sources, which together can supply no more than half of the injection. On a $2 million purchase with no other project costs:
- The required injection is $200,000, and a full standby seller note can supply at most $100,000 of it.
- The other $100,000 must come from unlimited sources, such as the buyer's own unborrowed cash.
- Any further seller note does not count as equity, and it can receive payments only if total debt stays within the business valuation and what cash flow can service.
SOP 50 10 8 restored the full-term standby and half-injection cap in June 2025, replacing a 24-month standby used since 2023, and SOP 50 10 8.1 kept both. Because earnouts are prohibited in SBA-financed changes of ownership, and a seller in an initial acquisition can stay only as a consultant for up to 24 months, the note is usually the seller's main remaining stake in the business.
Seller Notes in Sources and Uses and the Returns Math
Where the Note Sits in Sources and Uses
In a sources and uses table, the seller note is a source of funds: it pays for part of the price exactly as a loan would, except that no cash changes hands. Here is the HVAC deal, with fees left out to keep the arithmetic clean:
| Source | Amount | Multiple of EBITDA | Share of price |
|---|---|---|---|
| Senior bank loan | $10M | 2.5x | 50% |
| Seller note | $4M | 1.0x | 20% |
| Buyer equity | $6M | 1.5x | 30% |
| Total = purchase price | $20M | 5.0x | 100% |
The note lifts total leverage from 2.5x to 3.5x while leaving senior leverage at 2.5x, and it cuts the equity needed from $10 million to $6 million. Lenders accept it because their own position is unchanged and the note absorbs losses before they do; buyers ask for it because it shrinks their check.
How the Note Changes the Buyer's Returns
Assume EBITDA grows to $5 million over five years and the business sells at the same 5.0x, for $25 million. Without a note, free cash flow repays $5 million of the bank loan. With one, interest of $240,000 a year absorbs roughly $1 million after tax over five years, so only $4 million of the loan is repaid, and the note is paid off at exit.
| Five-year outcome | Without seller note | With seller note |
|---|---|---|
| Equity invested | $10M | $6M |
| Exit value | $25M | $25M |
| Senior debt at exit | $5M | $6M |
| Seller note repaid at exit | None | $4M |
| Equity value at exit | $20M | $15M |
| Multiple of money | 2.0x | 2.5x |
| IRR, approximately | 15% | 20% |
The buyer ends with $5 million less equity value yet earns a better return, because $4 million of cheap, fixed-cost capital replaced equity that would have needed a buyout-style return. That is financial leverage at work, and it cuts both ways, as the seller's downside case below shows.
Seller notes show up in paper LBOs and deal-structuring questions: Work through LBO, sources and uses and returns questions with worked answers, start practicing interview questions for free and see how a change in the capital stack moves IRR before an interviewer asks.
Risks for the Seller and What to Negotiate
What Can Go Wrong
A seller who takes a note stops being an owner and becomes a junior creditor of a more leveraged business run by someone else. The note is repaid from the same cash flow that services the bank, so a downturn reaches the seller after the lender, and payment blockage and standstills can freeze both payments and remedies for long stretches. Run the HVAC deal in reverse:
- EBITDA falls to $2 million and the business sells at 5.0x for $10 million.
- The $8 million of bank debt still outstanding is repaid in full.
- The seller recovers $2 million of the $4 million note, and the buyer's equity is worth nothing.
A bankruptcy follows the same order, and the recovery waterfall leaves a subordinated note near the back of the line.
What Sellers and Buyers Negotiate
The negotiation trades downside protection for the seller against flexibility for the buyer and its bank:
- Security: a junior lien behind the bank, or a personal or parent guarantee.
- Payment terms: cash interest rather than PIK, and some amortization, within what the lender allows.
- Acceleration triggers: repayment on a sale, a senior refinancing or a change of control.
- Information and covenants: regular financial statements and a cap on new senior debt.
- The buyer's asks: prepayment without penalty, broad set-off and freedom to refinance the senior debt.
Interviewers probe the same tension from the other side of the table.
Key Takeaways
- A seller note is part of the price lent back to the buyer, repaid with interest and ranked behind the senior lenders, which is how it fills the gap between debt capacity and price.
- US sellers can usually spread the gain under the installment method, though depreciation recapture is taxed upfront.
- The subordination agreement's blockage, standstill and turnover terms matter more than the rate.
- In SBA 7(a) deals a note counts toward the equity injection only on full standby, and for at most half of it.
- The note is a source of funds that shrinks the equity check and raises IRR, while leaving the seller exposed to default and set-off.
Conclusion
A seller note looks like a financing detail, one line in sources and uses between the bank loan and the equity. It is better understood as a risk transfer: the seller accepts a junior, deferred claim on a business they no longer control, and in return the deal closes, often at a higher headline price, with a smaller equity check and larger returns for the buyer.
The useful questions about any note therefore concern ranking and enforceability more than the coupon: who is paid first if cash runs short, what can stop payments and for how long, whether the buyer can set off claims, and what the note is worth once discounted for all of that.
Candidates who can move from the mechanics (a source of funds that raises IRR) to the judgment (a subordinated claim whose face value overstates the price) show they understand deal structure rather than its vocabulary.
