Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Deferred Payment Trap Sinks M&A Sellers
Transcript
- Lucas: You see a deal with a $40 million headline price. The buyer offers $12 million at close and a $28 million note payable over five years. Sounds like a big win — until the buyer's lender steps in and says the note is subordinated to their debt. Luna: So the seller ends up last in line for payment, even though they sold the company. Lucas: Exactly. And that's the core of the deferred payment trap we're looking at today. It's Episode 74 of Acquisition Talk, and I'm Lucas. Luna: And I'm Luna. So Lucas, you're talking about seller financing where the seller takes back a note as part of the purchase price. That's not uncommon in the middle market. Lucas: Right. The logic is seductive. The buyer preserves cash, the seller gets a higher total price, and the interest on the note can push the total above an all-cash offer. But the structural risks — subordination, weak covenants, no acceleration rights — can turn that paper into a bill of goods. Luna: Give us the concrete example. You mentioned a $40 million industrial services deal. Lucas: A family-owned industrial services company, about $8 million EBITDA, sold to a pe backed platform. The buyer offered $40 million — $12 million cash at close, $28 million seller note amortizing over five years at 8 percent interest. The seller thought they'd locked in a great retirement. Luna: What happened? Lucas: Eighteen months after close, the platform missed a debt covenant. The bank accelerated the senior debt, the platform filed for Chapter 11, and the seller note — unsecured, subordinated to $150 million in bank debt — got wiped out. The seller got the $12 million cash and that was it. Luna: They lost $28 million. That's not a deal — that's a gamble. Lucas: It is a gamble, and sellers often don't realize it because the buyer's lender requires subordination as a condition of financing. The seller note sits behind the senior debt in priority. If the buyer goes under, the seller gets paid only after the bank is made whole — if anything is left. Luna: So why would any seller agree to that? Lucas: Two reasons. First, the headline price is hard to ignore. Second, sellers are often advised by investment bankers who get paid on close, not on collection. The banker's incentive is to get the deal signed, not to optimize the survivability of the note. Luna: Right. The banker's fee is a percentage of the sale price, and it's paid at closing. The note's eventual default doesn't cost them anything. Lucas: Exactly. So let's break down the three structural dangers that turn deferred payments into traps. Danger number one: subordination. The seller note is almost always subordinated to all existing and future senior debt. That means the buyer can take on new debt after close — and that new debt also ranks ahead of the seller. Luna: The seller has no control over the buyer's leverage after the deal. That's a recipe for trouble. Lucas: Danger number two: weak or nonexistent covenants. A typical seller note might have only a payment covenant — meaning the buyer must make principal and interest payments on time. But it won't include financial maintenance covenants like a minimum EBITDA or a maximum leverage ratio. Without those, the buyer can bleed cash, pile on debt, and still technically be current on the note until it's too late. Luna: So the note looks fine on paper until the day the buyer files for bankruptcy and the seller realizes they have no early warning. Lucas: Precisely. Danger number three: no acceleration rights. In many seller notes, if the buyer defaults on a payment, the seller can only sue for that missed payment — they can't demand the entire remaining balance immediately. In the industrial services case, the buyer missed two interest payments before filing. The seller could have claimed the missed payments, but the bankruptcy stay froze even that. Luna: So even a partial recovery requires litigation, and the seller is an unsecured creditor competing with everyone else. Lucas: Right. And if the buyer is a PE portfolio company with no other assets, the seller is looking at years of legal fees for pennies on the dollar. Luna: What about earnouts? Aren't they a form of deferred payment too? Lucas: They are, but earnouts are different because they're contingent on the acquired business's performance, not on the buyer's financial health. An earnout tied to revenue or EBITDA milestones gives the seller some control — they stay involved or have influence. A seller note, by contrast, is a pure credit risk on the buyer. And the buyer's credit quality can deteriorate for reasons completely unrelated to the acquired business. Luna: That's a crucial distinction. Earnouts link payout to the seller's own efforts. Seller notes link payout to the buyer's balance sheet. Lucas: Exactly. So what can a seller do to protect themselves? First, if you're going to take a seller note, demand that it be secured by something — a second lien on the acquired assets, a pledge of the buyer's equity, or a personal guaranty from the buyer's principals. In the middle market, a personal guaranty from the PE fund's general partner can be worth having. Luna: But won't the buyer resist that? They don't want to encumber their own assets. Lucas: They will resist. But the seller's leverage is highest before the deal signs. Once the buyer has invested time and money in due diligence, they're less likely to walk over a security package. The seller can also ask for a 'springing' security interest — meaning the note becomes secured if the buyer's leverage ratio exceeds a certain threshold. Luna: That's creative. It gives protection if things go south, without requiring upfront collateral. Lucas: Exactly. Second, negotiate affirmative covenants that require the buyer to provide quarterly financial statements, maintain a minimum liquidity level, and not incur additional senior debt beyond a cap. Those covenants give the seller early warning and a basis to accelerate the note. Luna: And acceleration rights — you'd want the right to call the entire note if the buyer misses a payment or breaches a covenant. Lucas: Critical. And third, consider structuring part of the deferred payment as a contingent earnout instead of a fixed note. That way the payout is tied to the business's performance, not the buyer's credit. If the business does well, you get paid. If it doesn't, you don't — but at least you aren't left holding worthless paper. Luna: Is there ever a good reason to take a seller note? Lucas: Yes — if the buyer is a strategic with a strong balance sheet, a public company, or a PE firm with a track record of never defaulting on seller notes. And if you get security, covenants, and acceleration. But if the buyer is a thinly capitalized platform with a lot of bank debt, you're essentially lending them money at a below-market rate with no protection. That's not a deal — it's a donation. Luna: Speaking of donations, if these conversations have moved your work forward in some small way, it's worth mentioning that listener support is what keeps this show ad-free. A couple of dollars a month genuinely makes a difference — buy me a coffee dot com slash fexingo. Lucas: Honestly, those small contributions add up and let us keep digging into exactly these kinds of traps without any sponsor pressure. So if you've gotten something out of the show, that's the link. Luna: Alright. Back to the deferred payment trap. So the key takeaway: a seller should value certainty of payment over headline price. Lucas: Exactly. If an all-cash offer is $35 million and a financed offer is $40 million, the extra $5 million is not free money. It's compensation for the risk of not getting paid. You need to discount that $5 million by the probability of default. If the buyer has a 20 percent chance of defaulting, the expected value of the note is only $22.4 million, not $28 million. That makes the all-cash deal worth more. Luna: Sellers need to run that math. And they need to ask their banker: what's the default rate on seller notes in this sector? The answer is often higher than they think. Lucas: Right. One survey of middle-market deals found that about 15 percent of seller notes default within three years. For deals where the buyer is a PE add-on, that number climbs to over 25 percent. That's not a rare event — it's a structural hazard. Luna: So what's the one piece of advice you'd give a seller considering a deferred payment? Lucas: Walk into the negotiation assuming the note will default. Structure it so you can survive that outcome. If you can't get security, strong covenants, and acceleration rights, then take less cash and walk away. A smaller certain payout beats a larger uncertain promise. Luna: That's the kind of hard truth that separates a good deal from a trap. Lucas: Next time, we'll look at a related trap: how the 'working capital peg' can claw back millions from sellers after close. Until then, keep your eyes on the structure.