The buyer wants to use seller financing but is demanding a subordinating agreement that prevents us from taking action on their default if their senior cash flow leverage ratio exceeds three times EBITDA. How do we structure our default triggers to maintain leverage without violating their senior lender bank covenants?

Question

Tyler Smith · Accepted Answer

When a buyer requests a subordination agreement that prevents you from taking action on their default if their senior cash flow leverage ratio exceeds three times EBITDA, they are essentially asking you to waive your rights to accelerate payments. This is a common demand from senior lenders who want to protect their position and ensure their line of credit isn't jeopardized by a junior lender's actions. However, accepting a blanket standstill clause can severely limit your ability to protect your investment.

Structuring Default Triggers and Protections

To balance the senior bank covenants with your financial security, consider these strategies for structuring your seller note and subordination agreement:

• Carve-Out for Operational Defaults: Negotiate a specific carve-out in your subordination agreement. This allows you to take action on operational defaults that do not directly trigger financial payment acceleration or violate the senior lender's covenants. This preserves your ability to intervene if the business's underlying operations falter, rather than just waiting for financial distress.
• Limited Standstill Period: Instead of an indefinite block on action, negotiate a limited standstill period, such as 90 days. This gives the buyer a chance to cure the default, but also ensures you regain your right to assert your remedies once the cure period expires. This ensures you maintain control over your investment, preventing a scenario where your note is effectively frozen due to senior debt restrictions. For more on protecting your interests in a deal, see [structuring seller notes subordination remedies](/qa/structuring-seller-notes-subordination-remedies).
• Automatic Board Seat or Observer Rights: Insist on a covenant that automatically grants you a board seat or observer rights if the buyer misses two consecutive payments. This provides you with direct insight into the business's performance and decision-making, allowing you to monitor the situation closely and potentially influence corrective actions.
• Equity Conversion Rights: Structure the note to allow for equity conversion. If the buyer defaults and cannot pay due to restrictions imposed by senior debt, your debt converts into senior preferred equity with voting rights. This gives you a more powerful position within the company structure and a say in its future direction, protecting your capital.
• Key Personnel Covenants: Implement covenants tied to the buyer's leadership and operational stability.
• Using your company's existing [EOS® Accountability Chart](/qa/how-can-ai-optimize-the-accountability-chart-for-eos-organizations-undergoing-exit-planning), draft the note to state that key leadership positions must remain filled by qualified individuals who meet GWC™ standards (Gets it, Wants it, Capacity to do it).
• If the buyer replaces your capable leaders with unqualified staff, this triggers a non-monetary default. This contractual right allows you to step back in and stabilize operations before your capital is destroyed by mismanagement. This type of provision is crucial for businesses where the team is a key asset, similar to documenting [operational playbooks for strategic premium multiples](/qa/operational-playbooks-for-strategic-premium-multiples) to prove turn-key operations.

By incorporating these specific clauses, you can maintain leverage and protect your investment without violating the buyer's senior lender bank covenants. This ensures you have recourse and visibility even when your note is junior to the primary financing.