The buyer is asking for a seller note representing fifteen percent of the transaction value but is planning to load the business with senior debt to fund the cash portion. How do we structure covenants in our note to prevent them from stripping cash out through dividend recapitalizations before our note is fully repaid?

Question

Tyler Smith · Accepted Answer

When a buyer loads up your business with senior bank debt, your seller note sits in a highly vulnerable position. The biggest risk is not just normal operational failure; it is the buyer recapitalizing the company to pay themselves a massive dividend, leaving you holding an empty shell. To protect your capital, you must negotiate restrictive covenants directly into the subordinated promissory note. Start by insisting on a strict limitation on distributions. This covenant must block any dividends, member distributions, or parent company management fees as long as the seller note remains unpaid, except for tax distributions if the company is structured as a pass-through entity. Additionally, you need a debt incurrence covenant. This limits the total amount of senior debt the buyer can layer ahead of you. Tie this limit to a leverage ratio, such as two times EBITDA. If they exceed this ratio, it triggers an immediate default on your note, accelerating the payment. Finally, establish a mandatory prepayment trigger. If the buyer decides to sell a significant portion of the company assets or undergoes a change of control, your note must be repaid in full immediately. Do not rely on their goodwill. Bring these parameters to your weekly Level 10 Meeting™ with your leadership team and have your integrator align these covenants with your legal counsel before signing the letter of intent. This ensures your hard-earned equity is not stripped away to fund the buyer's next acquisition.