Seller financing has long played a crucial role in small business acquisitions, especially when an attribute of the deal is not palatable to the Buyer or Underwriting. With the recent changes to the SBA SOP, seller note requirements and uses have changed… changed… not died. These new regulations create opportunities to creatively mitigate deal specific hurdles in the hands of the well-informed.
Contrary to popular belief, Seller Notes within an SBA Financed Business Acquisition Are Not Dead!
In my opinion under the new regulations, there are three strategic uses of Seller Notes: (1) notes on full standby for the life of the SBA loan, (2) forgivable notes used to mitigate risk factors, and (3) seller notes on limited standby for two years that can impact the debt service coverage ratio (DSCR). Each variation has unique implications for borrower equity, underwriting, and deal structure.
1. Seller Notes on Full Standby for the Life of the Loan
One of the most powerful tools available in SBA acquisition financing is the seller note placed on full standby for the life of the loan. Under the new SBA regulations, if the note is on complete standby, meaning no payments of principal or interest are allowed until the SBA loan is fully paid, it can count as up to 5% of the required borrower equity injection.
Why This Matters
When acquiring a business, SBA requires borrowers to inject a minimum equity contribution, often 10% of the total project cost. This can be a significant hurdle for buyers, especially first time entrepreneurs or those with limited liquidity. A seller note structured properly on full standby effectively reduces the buyer’s required cash injection from 10% down to as little as 5%, making the deal far more accessible. This should widen your pool of qualified buyers, so I recommend floating the use of seller financing early, especially if the seller wants to quicken the pace of the sale.
Please note: while reducing the borrower’s equity injection to 5% may help preserve cash, it does not waive or lessen the borrowers obligation to meet the bank’s post-closing liquidity (Murphy’s Law Money) guidelines.
For example:
- Total project cost: $1,000,000
- Required equity (10%): $100,000
- Borrower cash injection: $50,000 (5%)
- Seller Note on full standby for the life of the loan: $50,000 (5%)
In this case, the seller note fulfills half of the borrower’s equity requirement.
Benefits
- For buyers: Lower upfront capital requirement, greater access to ownership opportunities.
- For sellers: Demonstrates confidence in the business, potentially widens the buyer pool.
- For lenders: Satisfies SBA’s minimum equity injection while providing added security through seller participation.
Risks
- The seller must be comfortable waiting many years before receiving payment.
- If the business underperforms, sellers may never fully recover their standby note.
2. Forgivable Seller Notes for Risk Mitigation
In some cases, an acquisition presents specific risks that make lenders uneasy, such as customer concentration, asking prices above appraisal, or declining revenues. Here, a forgivable seller note can help close the gap.
How It Works
A forgivable note is essentially a contingent payment obligation. The note is structured so that repayment depends on future business performance or the satisfaction of certain conditions during a set time frame post-closing (typically 2-3 years). If those conditions are not met, the seller agrees to forgive all or part of the obligation.
Use Cases
- Customer concentration: If one customer makes up a significant percentage of revenues, the note may be forgiven if that customer departs within the time frame.
- Over-appraisal pricing: If the business sells for more than the appraised value, the seller note can absorb the excess. Should the business struggle, the note may be reduced or forgiven to bring the effective purchase price in line with true market value.
- Declining revenues: Granted, no one wants to try and catch a falling knife, but a forgivable seller note may serve as a performance buffer – if revenues continue to decline post-sale or a return to historical revenues, profits, or another metric, repayment may be waived.
Benefits
- For buyers: Could mitigate the risk of overpaying for the business, losing an important customer, or other concern.
- For lenders: Provides additional comfort that borrower cash flow will not be overburdened in adverse scenarios.
- For sellers: Still allows for a higher asking price upfront while offering flexibility to buyers and lenders.
Considerations
Borrower’s attorney and Lender’s attorney must carefully draft the note, the forgiveness conditions, and ensure clarity and compliance. While the SBA program does not allow earn-outs, forgivable notes are permissible when structured as conditional forgiveness rather than contingent payments. At the end of the day, the note must be written to benefit the borrower.
3. Seller Notes on Standby for Two Years
The third common variation involves seller notes placed on standby for two years. In this structure, the borrower does not make payments of principal or interest during the standby period, but payments may resume afterward.
Why This Matters
When calculating DSCR (Debt Service Coverage Ratio), SBA requires lenders to include all repayment obligations in the analysis. However, if the seller note is on at least two years of standby, the payments could be excluded from the DSCR calculation during underwriting (at many banks, including mine).
This is particularly useful when the buyer’s projected cash flow is tight. By pushing seller note payments outside of the SBA’s DSCR model for the first two years, lenders can demonstrate compliance with SBA’s underwriting standards while still allowing for seller participation.
Benefits
- For buyers: Improves the DSCR calculation, increasing chances of loan approval.
- For sellers: Still allows eventual repayment without committing to life-of-loan standby.
- For lenders: Creates flexibility in structuring deals where near-term cash flow is constrained.
Example
- Business acquisition price: $1,200,000
- Business Appraisal: $1,000,000
- SBA loan: $900,000 (90% of appraisal)
- Buyer equity injection: $120,000 (10% of project size)
- Seller note (2-year standby): $180,000
Because the $180,000 note is on standby for two years, it does not affect DSCR at underwriting and potentially bridges the valuation gap. After two years, payments begin, but ideally by then the borrower has stabilized operations and improved cash flow.
Putting It All Together: Strategic Structuring of Seller Notes
Each type of seller note serves a different strategic purpose (more than one seller note may be deployed to solve different hurdles):
- Full standby (life of loan): Helps meet SBA equity injection requirements.
- Forgivable notes: Mitigate valuation and performance risks.
- Two-year standby: Eases DSCR constraints during underwriting.
When combined thoughtfully, these tools allow for more flexible and creative deal structures. For example, a complicated transaction might include (all 3 would be a rarity but possible):
- 5% borrower cash equity,
- 5% seller note on full standby to meet the equity requirement,
- An additional seller note on 2-year standby to cover a financing gap,
- And a forgivable note tied to customer retention, providing lender protection.
Key Takeaways for Borrowers, Sellers, and Lenders
- Seller alignment matters. Notes on standby demonstrate that the seller has confidence in the ongoing viability of the business.
- Documentation is critical. SBA requires clear evidence of standby terms, forgiveness conditions, and repayment schedules.
- Flexibility creates deal flow. Properly structured seller notes expand the pool of qualified buyers and make SBA financing possible for transactions that might otherwise fail.
- Risk and reward must balance. While these notes provide important benefits, they also carry risks for sellers, who may wait years for repayment—or in the case of forgivable notes, never receive full repayment.
Conclusion
Seller notes remain a cornerstone of SBA business acquisition financing. Whether structured as equity injection support, forgivable risk mitigators, or DSCR-friendly instruments, they allow deals to move forward that might otherwise stall. For buyers, they reduce upfront cash needs and risk exposure. For sellers, they enable higher transaction values and a wider buyer pool. For lenders, they provide comfort that SBA requirements are being met without overburdening borrower cash flow.
The key is understanding the nuances of each type of seller note and structuring them in compliance with SBA guidelines. With proper planning, seller notes could transform a deal complication from dying on the vine into one that aligns the interests of buyers, sellers, and lenders alike which makes it to the closing table!
Mark Nichols, VP SBA BDO
Phone: (931) 572-8901
Email: mark@sbabizloan.com
Mark brings over 20 years of experience partnering with business owners to secure financing solutions with flexible terms. With a strong focus on building lasting relationships, he takes the time to fully understand each client’s financial goals, allowing him to deliver SBA loans that support long-term success and growth.