The buyer wants us to carry a seller note for twenty percent of the transaction value, but we are worried they will run the company into the ground and default. How do we structure covenants and security in the note to protect our downside without violating their senior lender's subordination terms?

Question

Tyler Smith · Accepted Answer

Carrying a seller note means you are acting as a junior lender, which places your capital behind the buyer's senior bank. To protect your investment without causing a deadlock with the senior lender, you must negotiate specific, non-monetary operational covenants directly into the subordination agreement.

First, secure the note with a junior lien on the business assets and a personal guarantee from the buying entity's principals. While the senior bank will restrict your ability to foreclose on assets during a default, you can structure covenants that trigger immediate consequences if key performance metrics are missed.

Define clear operational red lines. For instance, if the company's debt service coverage ratio drops below one point two, or if key customer retention falls below eighty percent, the buyer must grant you observer rights on their board of directors. You can also negotiate a step-up interest rate that increases the cost of the note if they fail to meet agreed operational milestones.

Additionally, use your Accountability Chart to maintain visibility. Require the buyer to deliver monthly financial packages and operational scorecards. This ensures you are not flying blind. If they breach these covenants, you can structure the note to allow for the acceleration of the debt or the conversion of unpaid interest into equity, giving you a path to regain control before the business is permanently damaged. Keep the terms clean, objective, and focused on operational health.