The capital stack hierarchy — priority of payment in M&A.

Cash at close is removed from the stack immediately and carries no recovery risk. Seller Notes, Earnouts, and Rollover Equity remain trapped inside the buyer's capital structure. In distress, upper tiers must be paid in full before lower tiers see a dollar. The hierarchy dictates that sellers are often subordinated creditors to the business they once owned.

§ 01 · Senior Debt — the first priorityThe Pole of Maximum Security.

First Lien security and control. Senior lenders hold a first lien on all company assets (receivables, client lists, intellectual property). In liquidation they are legally entitled to seize and sell these assets to recover principal before any other party. Senior debt is governed by strict financial covenants — primarily the Debt Service Coverage Ratio (DSCR) and Leverage Ratio. If the agency's performance dips and trips a covenant, the bank effectively gains control of the cash flow.

Payment Blockage rights. The most dangerous mechanism for sellers is the Payment Blockage provision in the Intercreditor Agreement. If the buyer defaults on senior debt — or even comes close, depending on the agreement — the senior lender can unilaterally freeze payments to all junior creditors, including the Seller Note holder. The seller can hold a "current" note while receiving zero cash for 180 days or longer.

§ 02 · Seller Note — the subordinated mezzanine layerThe Hope Note dynamic.

The Seller Note acts as Mezzanine Debt — bridging the gap between what the bank will lend and what the seller demands. While it is a debt obligation with a fixed maturity, it is deeply subordinated.

Subordination reality. Seller notes are contractually subordinated to Senior Debt. In bankruptcy, the seller receives nothing until the bank is made 100% whole. This creates the Hope Note dynamic — the seller hopes the business succeeds because there is no safety net if it fails.

Standstill Periods. If the buyer defaults, the Subordination Agreement typically imposes a Standstill Period (often 180 to 365 days). During this time the seller is legally prohibited from suing the buyer, foreclosing on collateral, or accelerating the debt. The seller must watch passively while the senior lender manages the distress.

Security posture matters. Sophisticated sellers negotiate for a Second Lien on assets or a Stock Pledge Agreement. While this ranks behind the bank, it places the seller ahead of general unsecured creditors (trade vendors, earnout holders). For SBA-financed deals under $5M, the note may be forced into Full Standby (no payments) for the life of the SBA loan — effectively pushing it down to an equity-like risk profile.

§ 03 · Earnout — the unsecured contingent liabilityThe double contingency.

Earnouts occupy a precarious position. They are unsecured contractual promises to pay, contingent on future performance.

General Unsecured Creditor status. Unlike a Seller Note (which may have a Second Lien), an earnout is rarely secured. If the buyer becomes insolvent, the earnout holder acts as a General Unsecured Creditor. In liquidation scenarios this tier typically recovers 0–10% of owed value.

The Double Contingency. Earnouts face a unique dual risk: performance risk (the business must hit revenue or EBITDA targets to generate the liability) and credit risk (the buyer must have liquidity to pay the liability). If the buyer is highly leveraged — particularly when funded by PE with 6× debt — senior lenders may block earnout payments if they threaten the company's liquidity, even if the targets were hit.

§ 04 · Equity — the residual claimDebt wipeout above 6× leverage.

Rollover Equity (reinvestment into the buyer's platform) sits at the very bottom of the Capital Stack. It is the First Loss tranche.

The waterfall and debt wipeout. Equity holders have a Residual Claim — entitled only to what remains after all debt (senior, mezzanine, seller notes) and transaction fees are paid. Debt Wipeout: if the platform is leveraged at 6× EBITDA and sells at 5.5× EBITDA, the equity value is zero. High leverage acts as a multiplier for risk — a small decline in enterprise value can result in a 100% loss of equity.

Preferred versus Common subordination. Within the equity layer there is often a sub-hierarchy. PE firms typically hold Preferred Equity with a Liquidation Preference (e.g., capital back plus 8% return before anyone else). Sellers rolling over typically receive Common Equity. The trap: if the exit is mediocre, Preferred holders may consume all available proceeds, leaving Common holders with nothing — despite technically owning equity.

§ 05 · Recovery math by tierWhat the protections actually buy.

Senior Debt — approximately 100% recovery in typical distress. Seller Note with stock pledge and UCC-1 — 30–70% recovery range depending on residual agency value. Unsecured "Hope Note" — 0–10%. Earnout (default unsecured) — 0–10%, with letter of credit, escrow, or parent guarantee improving outcomes. Preferred Equity — 50–100% depending on liquidation preference. Common or Rollover Equity — 0 to whatever residual remains, with tag-along, put option, leverage cap, and board seat being the protective tools.

Key trigger thresholds: DSCR below 1.25× triggers senior covenant breach and payment blockage. Leverage above 6.0× EBITDA creates equity wipeout risk. Standstill periods run 180–365 days typical.

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