Sometimes business sales are structured so that part of the purchase price is the Buyer’s cash, part of the purchase price is derived from a Senior Loan obtained by the Buyer, and the remainder of the purchase price is evidenced by a promissory note (“Note”) from the Buyer to the Seller. Usually, the Senior Lender requires that the Note be subordinated to the Senior Loan under a Subordination Agreement. Senior Lender Subordination Agreement forms may prohibit payments on the Note until the Senior Loan is repaid, prohibit collateral for the Note, and/or require the Note to be assigned to the Senior Lender. The Senior Loan might be a revolver, meaning that the principal of the Senior Loan may be repaid and reborrowed, and the principal balance of the Senior Loan may be the same at its inception and at maturity. If the Senior Loan is refinanced, the new Senior Lender will likely also require a Subordination Agreement. The Seller then has to choose between signing the new Subordination Agreement and extending the Note maturity, or risk acceleration of the existing Senior Loan and foreclosure or disposition of any collateral pledged to secure the existing Senior Loan. The Senior Loan is sometimes refinanced multiple times and each Subordination Agreement prohibits payments on the Note until the new Senior Loan is repaid, delaying the repayment of the Note with each refinancing. The Note is sometimes called a “Hope Note” because the Note repayment is indefinite. Unless it is assigned to the Senior Lender, the Seller should retain the right to assign the Note as collateral for a Seller’s debt or to a Note purchaser, but due to the uncertainty of repayment, the value will be dependent on the likelihood and timing of payments on and repayment of the Note.

The purpose of this article is to outline a structure for understanding and determining what provisions could be included to enhance the likelihood of payment on a Note and how to implement these provisions. Every sale is unique. This is not a “one size fits all” formula.  It is a toolkit of provisions and the rationale for negotiating them.  If the Seller is distressed or has little leverage, the Note amount is not a key part of the sale price, or the Senior Lender is unwilling to negotiate, then it may not make sense to try to include these provisions. Some provisions result from the evolution of, and increase in, Senior Lenders’ tolerance to permit subordinate Note payments over the years. Additional payment enhancements which may work with careful thought, discussion and drafting, particularly in businesses with the potential for growth, and the rationale for them, are explained. Other provisions are taken from traditional third party multi-lender and lender-investor agreements that are designed to enable the Seller to preserve the value of the Note or take over the business in the event of a default under the Senior Loan or certain defaults under the Note. 

Over the last 10 years, Senior Lenders have been more willing to allow “regularly scheduled” interest and/or principal payments on the Note so long as the Senior Loan is not in default and, in some cases, financial covenants are met. Fixed principal and fixed or variable interest payments may be regularly scheduled in the Note. If funds are insufficient to pay interest or interest payments are not permitted,  State law governing the Note (e.g. Texas law), may allow contractual agreements in the Note to compound interest when due and add it to the Note principal. In some cases, maturity date payments may be expressed as regularly scheduled. Less frequently discussed is the application of distributions. Payments from distributions of excess proceeds from the business permitted by the Senior Lender are also a possible source of Note repayment and may be expressed as regularly scheduled. Since the distributions are not retained in the business, the Senior Lender may be willing to allow them to be applied to the Note. Payments on the Note from distributions of excess proceeds could benefit the Senior Lender by reducing the amount of the subordinate Note claim in case of the bankruptcy of the Buyer. Payment of full of the Note from distributions of excess proceeds could benefit the Senior Lender by eliminating the Subordinate Lender as a competing creditor in case of the bankruptcy of the Buyer, clearing the path to the Senior Lender’s repayment. Alternatively, Sellers may have leverage to restrict distributions until the Note is paid so the business remains viable and able to repay the Senior Loan and the Note. 

As additional enhancements to the payment of the Note, Sellers may be able to restrict the maximum size of the Senior Loan and the ability of the business to add additional debt. They may also be able to restrict the equity owners’ ability to transfer their Equity Interests in the Buyer so no change of control occurs, and to prohibit a sale of all or substantially all of the business assets, or an assignment of the Note by the Buyer. In order to be effective, the occurrence of any of these actions should be designated as void, and not just voidable. These enhancements assure the continued operation by a Buyer the Seller knows until the Note is repaid. In connection with these enhancements, the Seller may be able to require the business to meet financial covenants and to provide the Seller with financial reporting to monitor compliance with them. Making these requirements mirror those in the Senior Loan, and providing that they continue after the Senior Loan is repaid, may make them easier to negotiate. Depending on the complexity of the Seller-Buyer agreement, the Senior Lender may also permit amendments to the Note documents that do not increase the principal amount, rate of interest, or schedule of payments on the Note.

However, it is unlikely the Senior Lender will permit acceleration of the Note because of the Buyer’s failure to make a permitted payment on the Note, or any other default under the Note. Therefore, except for preventing Seller actions that are agreed upon as void, it may be the case that a Note default only permits the imposition of a default interest rate, unless the Seller is able to negotiate Intercreditor provisions discussed below.

In traditional multi-lender or lender-investor transactions, subordinate lenders often take a security interest in the Equity Interests of the business owners to secure their Note, in certain obligations under an investment agreement, and/or a guaranty of the Note or those obligations.  Less common is a security interest in the business assets (with exceptions for assets not pledged to the Senior Loan), as the Senior Lender usually will not permit a Subordinate Lender security interest in assets which are the Senior Lender’s collateral. Usually, the Senior Lender will require a Subordination Agreement, and the Subordinate Lender will try to include Intercreditor provisions in a Subordination and Intercreditor Agreement between the Senior Lender and Subordinate Lender to permit acceleration of the subordinate Note, foreclosure of the Equity Interests and any other collateral for the subordinate Note, and collection on a guaranty upon default under the subordinate Note or those obligations. The Senior Lender will require restrictions on the Subordinate Lender’s exercise of remedies on such collateral and guarantor (e.g. only to reimburse the Subordinate Lender if it has cured a default under the Senior Loan), and if they have the same guarantor or collateral, will include “shared guarantor/collateral” subordination provisions (e.g. except for reimbursements of Senior Loan default cures by the Seller, all proceeds are applied to the Senior Loan first). The Subordination and Intercreditor Agreement may also include Intercreditor provisions that would permit the Subordinate Lender (a) the right to amend the subordinate Note documents (e.g. amendments that do not increase the principal amount, rate of interest or schedule of payments on the subordinate Note), (b) notice and cure rights for defaults under the Senior Loan, (c) rights to purchase the defaulted Senior Loan, (d) rights to assume the Senior loan if the Subordinate Lender exercises rights to foreclose the Equity Interests, and/or (e) prohibitions on amendments to the Senior Loan that would increase the principal, fees, expenses or interest rate, or change the schedule of payment on the Senior Loan. A Subordination and Intercreditor Agreement, or modifications to Subordination Agreements to include Intercreditor provisions, can require extensive negotiations, including underwriting requirements for the assumptor of the Senior Loan.

If part of the purchase price will be evidenced by a Note to the Seller:

1. First, determine the basic terms of the Seller Note, and if additional enhancements are feasible:

1. What is the principal amount, interest rate, default interest rate and maturity date of the Note?
2. Is the Senior Loan a revolver, such that the principal amount of the Senior Loan may be the same at its inception and maturity?
3. Will the Seller be required to forgo all payments until the Senior Loan (which also may apply to any loan refinancing it) is paid in full?  If not, what can they expect to receive in payments (i.e. principal  and/or interest) while the Senior Loan (which may apply to any loan refinancing it) is in place?
4. If funds are insufficient to pay interest on the Note, or interest payments are not permitted by the Senior Lender, will unpaid interest be compounded and added to principal, if permitted under State law governing the Note, on monthly (or quarterly) payment due dates?
5. After payment of monthly (or quarterly) operating expenses and Senior Loan payments, if there are excess proceeds from the business that the Senior Loan permits to be distributed – “Excess Proceeds” – will all or part of the distributions (e.g. all except sufficient amounts for equity owners to pay income taxes relative to the business ownership) be applied to paydown the Note? If not, will distributions be prohibited, even though the Senior Loan may permit them, and the money retained in the business?
6. Will the Senior Lender require the Note be assigned to them until the Senior Loan (which may apply to any loan refinancing it) is repaid?
7. Will there be a limit on the total amount of the Senior Loan?
8. Will the Seller retain the right to assign the Note, either as collateral for Seller debt, or to a Note purchaser? 
9. Will the Buyer be prohibited from assigning the Note?
10. Will there be restrictions on future transfers of Equity Interests, a future sale of all or substantially all of the business assets, or additional debt? Can these mirror restrictions under the Senior Loan?
11. Will there be a security interest in the Equity Interests, business assets, or other assets that do not secure the Senior Loan to secure the Note or a guaranty? Will the Senior Lender permit the Seller to accelerate and foreclose on those Equity Interests or other assets, or collect on the guaranty if the Note and/or Senior Loan goes into default, other than a default in restricted payments on the Note? Except in the case of Equity Interests or reimbursement of Seller for its cures of defaults under the Senior Loan, will the proceeds be applied to the Senior Loan first?
12. Will the Senior Lender agree to traditional Subordinate Lender Intercreditor provisions in a Subordination and Intercreditor Agreement or the Subordination Agreement? These provisions are (a) the right to amend the Note documents (e.g. amendments that do not increase the principal amount, rate of interest or schedule of payments on the Note), (b) notice and cure rights for defaults under the Senior Loan, (c) rights to purchase the defaulted Senior Loan, (d) rights to assume the Senior Loan if the Seller exercises rights to foreclose the Equity Interests, and/or (e) prohibitions on amendments to the Senior Loan that would increase the principal, fees, expenses or interest rate, or change the schedule of payment on the Senior Loan.
13. Will the Seller be able to require the business to meet financial covenants and to provide the Seller with regular financial reporting to monitor compliance with them, and if so, what are those financial covenants? Can these mirror those under the Senior Loan.

2. Second, incorporate the substance of those determinations in a Term Sheet and/or Purchase and Sale Agreement provision. There is no market or reasonable standard for a Subordination Agreement, and some Senior Lenders consider a fully subordinated Note with no payments, and assigned to them, as their standard. Incorporating the provision upfront eliminates any surprises when a Senior Lender is named and will provide the basis for including the terms in any Subordination Agreement.

1. Include the principal amount, interest rate, default interest rate, and maturity date of the Note.
2. Include any scheduled payments (principal, interest, Excess Proceeds, maturity final payment) that should be permitted under any Subordination Agreement, so long as there is no default under the Senior Loan. Define Excess Proceeds. Include any compounding of interest.
3. Include any limit on the Senior Loan amount and/or restriction on the Senior Loan being a revolver. 
4. Include that the Senior Lender may not require the Note be assigned to them.
5. Include that the Seller can, but the Buyer cannot, assign the Note, and that any such assignment is void, and not just voidable.
6. Include any restrictions on transfers of Equity Interests, additional debt, or a sale of all or substantially all of the business assets, including if these will mirror any in the Senior Loan, and that the occurrence of any of these actions is void, and not just voidable.
7. Include any security interest in Equity Interests, business assets and/or other assets, and any right to foreclose on them, subject to or in assumption of the Senior Loan, and except for Equity Interests, how the proceeds will be applied.
8. Include any guaranty and how collection proceeds will be applied.
9. Include any Intercreditor requirements for a Subordination and Intercreditor Agreement (or modifications to a Subordination Agreement) –  (a) the right to amend the Note documents (e.g. amendments that do not increase the principal amount, rate of interest or schedule of payments on the Note), (b) notice and cure rights for defaults under the Senior Loan, (c) rights to purchase the defaulted Senior Loan, (d) rights to assume the Senior Loan if the Seller exercises rights to foreclose the Equity Interests, and/or (e)  prohibitions on amendments to the Senior Loan that would increase the principal, fees, expenses or interest rate, or change the schedule of payment on the Senior Loan.
10. Include any financial reporting, including if these will mirror any in the Senior Loan.

3. Third, prepare the Note and, if applicable, the Security Agreement including security interest perfection documentation and the Guaranty. If applicable, prepare language for Intercreditor provisions in case the Senior Lender does not have them, as a basis for negotiating the Senior Lender’s Subordination Agreement form. Include in the Note, as applicable:

1. Payments expressed as “regularly scheduled” as the Senior Lender is more likely to accept them. Include maturity date payments as “regularly scheduled,” although the Senior Lender may resist large ones. Define and include any Excess Proceeds payments that the Seller wants applied to the Note as “regularly scheduled” payments.
2. That unpaid interest will be compounded.
3. If Excess Proceeds are not applied to the Note, any restrictions on distributions.
4. Any restrictions on transfers of Equity Interests, additional debt, or a sale of all or substantially all of the business assets, including if these will mirror any in the Senior Loan, and that the occurrence of any of these actions should be designated as void, and not just voidable.
5. That the Note is secured by the Equity Interests, business assets and/or other assets, and reference the Security Agreement.
6. That the Note is guaranteed, and reference the Guaranty.
7. Any financial covenants and financial reporting, including if these will mirror any in the Senior Loan, and that they will continue after the Senior Loan is repaid.
8. Any prohibition on assignment without Seller consent, and include that any such assignment is void, not just voidable.
9. The Seller’s right to transfer the Note, either as collateral for Seller debt, or to a Note purchaser.

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