We are taking a significant seller note as part of our exit, but we are worried the buyer might mismanage the company post-close and default on our payments. How do we structure protective covenants in our note without violating the senior bank's subordination terms?

Question

Tyler Smith · Accepted Answer

When you accept a subordinated seller note, you are effectively acting as a junior lender. To protect your investment, you must negotiate covenants that give you early warning signs of operational decline before a default actually occurs. While the senior bank will restrict your ability to collect cash payments during a senior default, they will often allow non-monetary protective covenants.

Start by requiring the buyer to provide regular financial statements and operational reports. This ensures you can monitor the health of the business. Next, build explicit financial covenants into your note, such as a minimum debt service coverage ratio or a maximum leverage ratio. If the business breaches these ratios, it triggers a technical default under your note, even if they are still paying the senior lender.

If a technical default is triggered, structure rights that allow you to step in and advise. For example, you can require the buyer to participate in joint IDS® sessions or run structured Level 10 Meeting™ sessions to get the business back on track. In extreme cases, negotiate a stock pledge or an option to regain a seat on the board. By structuring these operational and financial triggers, you protect your capital without interfering with the senior lender's primary position.