What is a full standby seller note?

In the context of a small business acquisition, seller financing often accounts for some of the funding a borrower needs to buy a business. When a seller note is used in conjunction with an SBA 7(a) loan, the seller note is always subordinated to the SBA loan. In simple English, the seller note is second in line, behind the SBA lender, in getting paid off. Sometimes, the seller note can even be put on “partial” or full standby.

What does partial or full standby mean for a seller note?

When a seller note is put on standby in a business acquisition, it typically means that there are no payments made during the standby period. 

A seller note on partial standby typically means no payments are made for the first two years after the business acquisition closes.

A seller note on full standby typically means no payments are made for the duration of the SBA 7(a) loan, which has a standard term of 10 years, if no real estate is being purchased in the deal.

Although no payments are made to the business seller during the standby period, interest will still accrue on the outstanding principal.

Why would you need to be a seller note on standby?

Regardless of whether a seller note is put on full or partial standby, there are typically two drivers of standby arrangements:

1. The business will be tight on cash flow. Most lenders want a business to be clearing a 1.25 - 1.5x debt-service coverage ratio (DSCR). This means there is a 25-50% buffer in cash flow when accounting for the required debt service to the SBA lender and seller. Given many sellers aggressively negotiate the purchase price, it can be tricky to reach their price expectations while keeping DSCR above 1.25x – especially if the buyer does not want to invest a larger down payment. One solution to tight cash flow is to put the seller note on standby for part of the SBA loan. This allows the borrower to have more wiggle room in the early years of taking over the business.

2. A borrower is short on equity. Most banks will require at least 10% of the total project costs as a down payment from the borrower. This down payment can be funded by a mix of personal savings and liquid assets as well as equity investments from investors. For some deals, the borrower is short on the down payment. Perhaps the only have 5% of the total project costs available as a down payment. Or, they do not want to bring on investors to their acquisition. When this is the case, the seller financing note can count towards up to 5% of their equity injection if put on full standby. From the perspective of a lender, it can almost be treated as “equity” given there is no required payment during the term of the SBA loan.

What are the pros and cons of putting a seller note on Standby?

Like any approach to funding a business acquisition, standby clauses come with their pros and cons.

• Pro: It increases the buying power of a small business entrepreneur. Given that a bank will count the note as up to 5% of the buyer’s target 10% equity injection requirement, it can allow a borrower to buy a bigger business than they otherwise could (2x as large, in fact!).

• Pro: It gives the entrepreneur more leeway when coming into the owner’s chair. Oftentimes, EBITDA goes down in the first year or two after an acquisition, as employees demand raises and the entrepreneur invests in the business. By having a note on standby, the entrepreneur has to be less worried about immediately repaying the debt to the seller.

• Con: It is still debt. Despite “looking” like equity in the eyes of another lender, it will still come due for the entrepreneur. They need to be careful about building up cash flow and cash reserves, so that they can avoid defaulting on the seller note once it’s off standby.

• Con: It’s very challenging to negotiate. When talking to a seller, they’d often rather you find the money: either from friends and family or investors – or talk to other lenders. After all, you’re essentially asking them to sit on 5-10% of the total consideration for up to 10 years. Unlike equity, it’s not like they get a bigger payday if the acquisition is a success.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.