A search fund buyer is asking us to carry thirty percent of the purchase price in a seller note, but they have minimal outside institutional equity. How do we structure the default covenants and collateral in the note so we can step back into the business if they default?

Question

Tyler Smith · Accepted Answer

When dealing with a search fund or independent sponsor with limited balance sheet support, an unsecured or standard subordinated seller note is unsafe. If cash flows stumble, their senior lender will freeze subordinated payments and leave you holding uncollectible paper. You must secure the note with a springing equity pledge and definitive operational covenants.

Structure the seller note with a first-priority pledge of one hundred percent of the buyer entity equity, held in an independent escrow along with pre-signed stock powers and an irrevocable voting proxy. If the buyer defaults on scheduled principal or interest payments, fails to maintain a minimum Debt Service Coverage Ratio of 1.25x, or breaches defined operational guardrails, a thirty-day cure period begins. If uncured, the voting proxy activates automatically, allowing you to vote their shares, replace the board, terminate their management contract, and take back operational control.

Additionally, write negative covenants directly into the note agreement. The buyer must be prohibited from paying management fees to themselves or outside investors, increasing executive compensation, issuing dividends, or taking on subordinated mezzanine debt while any portion of your seller note is outstanding or in arrears. You should also secure quarterly financial delivery requirements identical to those demanded by their senior bank. This ensures you track their financials during quarterly reviews and see operational deterioration long before a covenant trips.