We are open to providing seller financing to achieve our target valuation, but we are worried about buyer default. What specific covenants, equity pledges, and default remedies must we secure in the promissory note?

Question

Tyler Smith · Accepted Answer

When you carry a seller note, you step out of the owner seat and into the lender seat. Never treat seller paper as an informal handshake or a secondary consideration. If the buyer mismanages the company, you need immediate legal authority to protect your capital before the business is hollowed out.

First, demand a senior pledge of the equity units sold. The buyer must pledge one hundred percent of the company stock or membership units as collateral, held by an independent escrow agent. If an uncured default occurs, ownership must revert to you through an expedited, non-judicial foreclosure mechanism rather than years of civil litigation.

Second, secure an unconditional personal guarantee from the primary principals or the acquiring fund parent entity. When buyers face personal recourse, your note does not get treated as discretionary capital when cash gets tight.

Third, include strict operational negative covenants within the note agreement:
- Debt incurrence caps that prevent the buyer from layering unapproved junior or mezzanine debt ahead of or alongside your loan
- Restrictions on dividend distributions, management fees, or capital withdrawals to the buyer while note payments are owed
- Minimum working capital and liquidity covenants that trigger a technical default before the company runs out of cash
- Direct information rights requiring quarterly audited or reviewed financial statements and monthly Scorecards delivered within twenty days of month end

Finally, negotiate cross-default provisions. If the buyer trips a covenant on their senior bank debt or defaults on any commercial lease, your note must automatically accelerate. That ensures you are sitting at the table during any creditor restructuring rather than waiting in line outside.