A seller note is a loan the seller of a business gives the buyer to cover part of the purchase price, repaid over time with interest instead of collected in full at closing. It typically covers 10 to 20 percent of the deal, sits behind any bank financing in payment priority, and effectively turns the seller into a lender to the person buying the company. Seller notes show up most often in lower-middle-market acquisitions, where senior debt and buyer equity together don’t stretch to the agreed price, and they tie a piece of the seller’s payout to the business’s continued performance.
Why Buyers and Sellers Agree to One
The plainest reason is arithmetic. A bank might lend 60 to 70 percent of the acquisition cost, the buyer puts equity in for another chunk, and there’s still a gap. The seller note fills it without forcing the buyer to bring in outside investors or abandon the deal.
Seller notes also break valuation deadlocks. When the buyer thinks a company is worth $4 million and the seller wants $4.5 million, financing the difference with a note lets both sides move forward. The seller books the higher price, and the buyer gets time to see whether the business’s cash flow actually supports it.
There’s a signaling effect too. A seller willing to carry paper is telling banks and investors that the person who knows the business best believes it can service additional debt. That confidence matters to lenders sizing risk. It also gives the buyer some built-in protection during the transition, because the seller now has a financial reason to cooperate rather than disappear the moment closing documents are signed.
Where the Note Sits in the Capital Stack
A seller note is almost always subordinated debt, meaning it ranks below the bank’s loan in priority. If the business runs into trouble, the senior lender gets paid first from available cash or liquidated assets. The seller collects whatever is left, which in a bad scenario can be nothing.
A typical acquisition capital stack looks like this:
- Senior debt in first position: a bank loan or SBA-backed loan covering 60 to 70 percent of the purchase price.
- Seller note in second position: subordinated to the senior lender, often 10 to 20 percent of enterprise value. Industry data puts the median around 12 percent for corporate buyers and closer to 18 percent for family offices and search funds.
- Buyer equity, last in and first to absorb losses: usually 10 to 20 percent of the deal.
Because the seller sits below the bank, the subordination agreement between the senior lender and the seller is one of the most consequential documents in the transaction. It controls what the seller can and cannot do when things go wrong, and both sides should read it carefully.
The Terms That Shape the Note
Interest Rate and the AFR Floor
Seller note rates in the current market generally fall between 6 and 11 percent. That’s higher than the bank’s rate on senior debt, reflecting the risk of a subordinated position with limited enforcement options.
The IRS sets a floor on the interest rate through the Applicable Federal Rate. Setting the stated rate below the AFR causes the tax code to recharacterize part of what would be principal as imputed interest, which changes the tax picture for both sides.1Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property The AFR is published monthly and varies by note duration: short-term for three years or less, mid-term for three to nine years, and long-term for anything longer. Most seller notes fall into the mid-term bucket given typical five- to seven-year terms, and as of early 2026 the mid-term AFR sits around 3.9 percent annually.2Internal Revenue Service. Rev. Rul. 2026-6 – Applicable Federal Rates for March 2026 Negotiated rates almost always clear this floor, but it’s worth confirming before finalizing terms. For the seller, a below-AFR rate means less of each payment qualifies for capital gains treatment; for the buyer, it can alter the depreciable basis of the acquired assets.3Office of the Law Revision Counsel. 26 U.S. Code 483 – Interest on Certain Deferred Payments Separate but related rules apply to demand loans and gift loans with below-market rates.4Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans with Below-Market Interest Rates
Payment Structure
Payments are usually monthly or quarterly, but the split between principal and interest varies. Three arrangements dominate:
- Fully amortizing. Each payment includes both principal and interest, and the balance is paid off by maturity. Simplest for both sides and safest for the seller.
- Interest-only followed by amortization. The buyer pays interest only for the first year or two, then begins full principal-and-interest payments. Useful when post-closing cash flow is unpredictable.
- Balloon. Smaller periodic payments, sometimes interest-only, with the remaining principal due in a single lump sum at the end of the term. A five-year note might amortize on a ten-year schedule with a balloon at year five. Balloons create refinancing risk: the buyer has to come up with the lump sum or find a new lender when it comes due.
Prepayment
The note should say whether the buyer can retire the balance early and what that costs. Buyers want flexibility; sellers want to protect the interest income they were counting on. Two penalty structures show up most often. Step-down penalties decline each year, say 3 percent in year one to 1 percent in year four. Yield-maintenance provisions calculate the fee from the gap between the note’s rate and current market rates. Step-downs are more common in seller-financed deals because they’re easier to calculate and negotiate.
How the Seller Gets Protected, and the Limits of That Protection
UCC Lien and the Subordination Trap
The seller’s primary security is a lien on the business assets, perfected by filing a UCC-1 financing statement with the appropriate state office. That filing puts other creditors on notice that the seller has a claim against equipment, inventory, receivables, and other property.
In practice this lien is nearly always subordinate to the senior lender’s security interest, and the subordination agreement between bank and seller tends to favor the bank heavily. Many of these agreements include a standstill provision that prevents the seller from taking any enforcement action against the buyer or the business assets until the senior debt is fully paid.5U.S. Securities and Exchange Commission. SEC Edgar – Subordination Agreement The standstill isn’t capped at some fixed period. It lasts until the bank is completely satisfied, which could be a decade or more. This is one of the biggest risks sellers carry: even if the buyer defaults on the seller note, the seller may be legally barred from acting on it while the bank works through its own remedies.
Personal Guarantees
Because the subordination agreement limits what the seller can recover from the business itself, sellers routinely require a personal guarantee from the buyer’s principals. A personal guarantee makes the individual personally liable for the debt rather than just the business entity. If the company fails, the seller can pursue the buyer’s personal assets. The guarantee is a separate contract that survives the entity’s potential insolvency, which is exactly what gives it value.
For buyers, signing one is a serious commitment that erases the liability shield an LLC or corporation would otherwise provide. Negotiating scope, whether the guarantee covers the full balance or declines with the remaining principal, is one of the more consequential conversations in any seller-financed deal.
Default and Acceleration
The note should define exactly what counts as a default. Common triggers include missing a scheduled payment, breaching a financial covenant such as a minimum debt-service-coverage ratio, or a change of control without the seller’s consent. Once default occurs, the seller’s core remedy is an acceleration clause, which lets the seller declare the entire unpaid balance immediately due. Without acceleration, the seller would have to sue for each missed payment separately. With it, the seller can demand everything at once and then pursue collection through litigation, foreclosure on collateral, or the personal guarantee. In practice, a standstill provision may still block those remedies until the senior lender is made whole.
Buyer’s Offset Rights
One provision cuts the other way. Buyers often negotiate the right to offset indemnification claims against the note balance. If the buyer discovers after closing that the seller breached a representation or warranty, for example by understating liabilities or overstating revenue, the buyer can deduct the resulting losses from what they owe on the note. The mechanism runs through a formal written notice specifying the nature and amount of the claim, with the offset taking tentative effect until the parties agree or a court resolves the dispute.
Sellers should recognize that the note functions as a built-in escrow for warranty claims. A deal without seller financing might require a separate escrow or holdback; a seller note gives the buyer a self-help remedy instead. Caps, baskets, and time limits on indemnification offsets are worth pushing hard for on the seller side.
Tax Treatment on Both Sides
The Seller: Installment Method
Sellers taking payments over time can generally report the gain using the installment method, which spreads capital gains tax across the years payments are actually received rather than recognizing everything in the year of the sale.6Office of the Law Revision Counsel. 26 U.S. Code 453 – Installment Method Each payment is split into three pieces: return of basis (not taxed), capital gain (long-term rates if the asset was held over a year), and interest (ordinary income).7Internal Revenue Service. Topic No. 705, Installment Sales
The method comes with real limits. Gain attributable to depreciation recapture on business equipment or machinery must be recognized in the year of sale, even if the seller hasn’t received all the payments; only the gain above that recapture qualifies for installment treatment. Dealer dispositions don’t qualify at all, and special rules apply to related-party sales. If a related buyer resells the property within two years, the original seller can be forced to recognize the remaining gain immediately.8Office of the Law Revision Counsel. 26 USC 453 – Installment Method
The Buyer: Deductions and 1099-INT
Principal payments aren’t deductible; they just reduce the liability on the balance sheet. Interest payments are deductible as a business expense in the year paid.
Federal law caps total business interest deductions at 30 percent of adjusted taxable income (roughly EBITDA), plus any business interest income. Excess interest carries forward but isn’t deductible in the current year. Smaller businesses that meet the IRS gross receipts test are exempt, so many lower-middle-market acquisitions won’t hit the ceiling. On larger deals with heavy debt across senior and subordinated layers, the 30 percent cap can meaningfully cut the tax benefit of seller note interest in the early years after closing.9Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest
If the buyer pays the seller $10 or more in interest during the year, the buyer must file Form 1099-INT with the IRS and send a copy to the seller.10Internal Revenue Service. About Form 1099-INT, Interest Income Buyers unfamiliar with this obligation sometimes miss it, which creates problems for both sides at tax time. The seller reports the interest as ordinary income whether or not the form actually arrives.
Seller Notes in SBA-Financed Deals
A lot of small business acquisitions run through SBA 7(a) loans, and the SBA has specific rules about how a seller note interacts with the government-backed loan. If the buyer wants the seller note to count toward the required equity injection, the note must go on “full standby.” Full standby means the seller receives no payments at all, principal or interest, for the entire life of the SBA loan. That period typically runs 10 years or more, and the note’s term must extend beyond the SBA loan’s maturity.
Even on full standby, the note can only count for up to half of the SBA’s minimum equity injection. If the SBA requires 10 percent equity, the seller note satisfies at most 5 percent, and the buyer supplies the other 5 percent in cash or other qualifying assets. The note is also automatically subordinated to the SBA loan, putting the seller in second lien position behind the government-backed lender.
Standby terms are a real sacrifice. Carrying paper that pays nothing for a decade has a time-value cost that belongs somewhere in the negotiated purchase price. Sellers who accept full-standby terms without adjusting the economics elsewhere are giving something up.
Seller Note vs. Earn-Out
Seller notes and earn-outs both put money in the seller’s hands after closing, and they get confused for that reason, but they aren’t the same instrument. A seller note is a fixed debt obligation. The buyer owes the money regardless of how the business performs. If revenue drops 50 percent the month after closing, every dollar of principal and interest is still due.
An earn-out is contingent. The seller receives payments only if the business hits defined performance targets, such as revenue or EBITDA thresholds, during a set post-closing period. Miss the targets and the earn-out pays nothing. Earn-outs shift more risk onto the seller and tend to appear when the parties disagree about future growth. A deal can include both: the note providing a guaranteed baseline and the earn-out giving the seller upside if the business outperforms.