We are carrying a significant seller note, and we want to prevent the buyer from stripping cash out of the operating entity via management fees. How do we structure the restrictive covenants?

Question

Tyler Smith · Accepted Answer

When carrying a seller note, you are acting as a creditor to your old business. A common risk is that the new buyer will attempt to strip cash out of the operating company by charging excessive management fees, consulting fees, or shared overhead allocations paid to their parent holding company, leaving the operating business with insufficient cash to service your note.

To prevent this, you must negotiate strict cash leakage covenants in your purchase and note agreements. First, place a hard cap on the total annual management fees the company can pay to the buyer or any of its affiliates. This cap should be a fixed dollar amount, not a percentage of revenue, and it must be fully subordinated to your note payments.

Second, include a covenant that prohibits any equity distributions, dividend payments, or share repurchases to the buyer's parent company as long as your seller note remains outstanding, or if a payment default exists.

Third, demand that the company maintain a minimum fixed-charge coverage ratio of at least one point two times, tested quarterly. If they fall below this ratio, all discretionary cash payments to affiliates must immediately stop. This protective ring-fence ensures the cash generated by the business goes toward paying down your debt.