We are carrying a substantial seller note that subordinates to the buyer's asset-based credit line. What specific financial covenants, information rights, and operational audit triggers can we write into the loan agreement to ensure the buyer does not run the business into default?

Question

Tyler Smith · Accepted Answer

Senior lenders will insist that your seller note takes a junior lien position and accepts standstill provisions. However, subordination to a bank does not mean surrendering your financial oversight. To protect your principal, you must negotiate enforceable operational covenants directly into your subordinated note agreement.

First, mandate strict monthly and quarterly information rights. The buyer must deliver reviewed financial statements, balance sheets, and a compliance certificate certifying their debt service coverage ratio within twenty days of month-end. You should also demand access to operational metrics similar to the EOS Scorecard you used to run the company, giving you visibility into leading indicators like sales pipeline volume and customer churn before financial distress appears.

Second, establish minimum liquidity and debt-service thresholds. If the buyer's fixed-charge coverage ratio falls below 1.15x, or if liquidity drops below an agreed floor, it must trigger a covenant default. While the senior lender will restrict your ability to seize assets during a standstill, a covenant default should immediately activate default interest rates, halt all management fees paid to the buyer's private equity sponsor, and grant you the contractual right to attend board meetings as an observer.

Third, prohibit discretionary distributions and affiliate transactions. The buyer cannot pull dividends or pay affiliated entities consulting fees while any principal or interest on your note remains outstanding. Writing these guardrails into the credit documents ensures the buyer cannot bleed company cash while leaving your capital at risk.