The buyer is asking us to carry a seller note for thirty percent of the purchase price but wants it subordinated to their senior lender and expects a payment in kind interest structure. How do we negotiate the protective covenants of this note to minimize our risk of non-payment?

Question

Tyler Smith · Accepted Answer

Carrying thirty percent of your enterprise value in a seller note presents significant risk, especially when it is subordinated to a senior lender. To protect your position, you must negotiate strict operational and financial guardrails before signing definitive agreements.

Key Protective Covenants

Here are essential protective covenants to negotiate:

• Default Rate Bump: Insist on a default rate bump of at least five hundred basis points if the buyer misses a payment. This provides a strong disincentive for late payments.

• Block Rights on Corporate Actions: Negotiate block rights on key corporate actions. The buyer should not be allowed to:
• Raise additional debt.
• Pay equity distributions to sponsors.
• Execute major acquisitions without your written consent while your note remains unpaid.

• Payment in Kind (PIK) Structure: To address a Payment in Kind (PIK) interest structure, negotiate a hard transition date. PIK interest must convert to cash payments within 12 to 18 months.

Monitoring and Enforcement

Effective monitoring and enforcement are crucial to minimize your risk:

• Tie to Company Metrics: You should tie the note's performance to the company's Scorecard metrics. For guidance on selecting meaningful metrics, refer to [how to narrow down our massive list of metrics](/qa/how-to-choose-five-fifteen-scorecard-metrics).

• Financial Reporting: Demand monthly financial statements and quarterly compliance certificates to monitor their debt service coverage ratio.

• Board Observation Rights: If they breach these covenants, you must have the right to attend their board meetings or install an independent observer. This keeps the buyer accountable and ensures you are not operating without full visibility.

Use your weekly Level 10 Meeting to keep your own leadership team focused on delivering a clean operational handoff, which remains the best mitigation strategy against post-close performance drops that could trigger a debt default. For more on Level 10 Meetings, see [owner exit transition Level 10 Meetings](/qa/owner-exit-transition-level-10-meetings). Understanding [what moves business valuation multiples](/qa/what-moves-business-valuation-multiples) can also provide context for the deal structure. If you're exploring how to structure such notes, consider [structuring seller notes and subordination remedies](/qa/structuring-seller-notes-subordination-remedies).