If we accept an installment note under Section 453, we want to include financial covenants in the seller note to monitor the buyer's leverage and debt service coverage ratio. How do we structure these covenants so we can intervene before the buyer drives the business into bankruptcy?

Question

Tyler Smith · Accepted Answer

When you accept an installment note under Section 453, you are acting as a lender, and you must protect your principal with the same rigor as a commercial bank. To prevent a buyer from mismanaging the company and defaulting on your note, you must negotiate positive and negative financial covenants directly into the promissory note. The most critical covenants to include are a maximum leverage ratio and a minimum debt service coverage ratio. The leverage ratio limits the amount of senior and subordinated debt the buyer can pile onto the business relative to its EBITDA. The debt service coverage ratio ensures the business generates more than enough free cash flow to cover all its debt obligations, including your installment payments. Require the buyer to provide quarterly, CPA-reviewed financial statements so you can actively monitor these metrics. If the buyer breaches a covenant, it must trigger an immediate event of default. This default status should grant you specific remedies, such as accelerating the payment of the entire note balance, increasing the interest rate, or gaining the right to appoint an observer to their board of directors. By structuring these guardrails, you can step in and protect your investment long before a bankruptcy occurs.