Seller Financing Series: Protecting Your Seller Financing Investment With Covenants

You’ve worked hard to build your company, have it just the way you want it, and now that the time has come to sell it…well, you’re naturally concerned that the new buyer will come along and make a ton of new changes that may hurt the company. If you making a cash sale, this affects mostly your ego, but if you are providing seller financing (a very common situation), it feels like this would affect your ability to get paid.  This fear often keeps sellers from wanting to consider seller financing. How valid is this fear? What if the buyer makes a lot of changes? This could be a problem if we are talking about changes that have a significant effect, negatively speaking, on the business. It is not necessarily a problem, however, if the buyer comes in and makes changes that will GROW the business.

I know these statements are obvious at first blush, but we need to have this basic understanding of what change means. We don’t want the buyer to make WRONG changes. We want the buyer to make the RIGHT changes. We want the buyer to come in and do things that we were never able to do, that is, take the business to the next level. In fact, hopefully, this is one of your goals in the sales process.

One of the ways to avoid “bad” changes in your business while you are still invested in it via seller financing is by ensuring your buy-sell agreement contains covenants, written guarantees beyond personal guarantees, that help ensure you will get paid.

Legally speaking, there is an approach that we can take to make sure that the buyer does not make too many changes that will ultimately damage the business. This is called a covenant. A covenant is a promise commonly found in the form of restrictions in a loan agreement imposed on the borrower to protect the lender’s interest. For our purposes, a covenant is a promise in a formal debt agreement that certain acts will be performed and other acts will not be performed.

Covenants are used frequently in Mid-sized transactions and in the merger and acquisitions world where there is a “second” lender. This second tier lender typically doesn’t have a personal guarantee from the principals of the company, nor do they have a “first lien” on the company’s assets. They are called Mezzanine lenders. I bring this up not because you don’t have a personal guarantee or a first lien against the assets of the company but because having the proper covenants in place on the sale of your business is sometimes just as effective as a personal guarantee and first lien position.

There are many types of covenants, tailored to the unique circumstances of your business. A covenant should be practical and not unduly restrictive. It should be something that you could “live” with if you were the buyer. When developing the “right” covenants for your business sale that you make a list of the areas that you would be most concerned about a buyer “changing” once coming into the business. Here are a few.

One comment that I hear a lot when companies pass from hand to hand is “will the new owner fire all the employees?” Personally, I think this is funny. Why? Because one of the biggest concerns that most all buyers have is “Will the employees stay once the business is sold?”

In fact, this is so common that both the buyer and the seller have the same concern. But either way, to make sure your employees (or most of them) are protected once you’re gone, you could set a covenant stating that the buyer must maintain 50% of the current staff as long as the seller note is owed.

To be fair to the buyer, it is possible for an employee to leave the business after closing. It is also very possible that the buyer had nothing to do with the loss of this employee. So if you consider using this type of covenant, do so with the buyer’s input.

The next area of concern that I frequently hear about is when the buyer may change a policy that is the key policy for your success. Well, first off, think about that for a minute. If it is “that” important, then you should be training the buyer during the training period. Most buyers are not going to purposely make changes that will ultimately hurt the profitability of the company. But if you locate some of the areas that you feel are a problem if the buyer changes them, then certainly talk to the buyer about adding a covenant in the loan agreement.

I can’t emphasize enough the power of communication in this process. The more you are communicating about these areas that should NOT be changed, the less likely the buyer is going to change them. And if you are still concerned about them being changed (ahem, you may not have the right buyer), you can always put a covenant in the loan documents that prevent the buyer from making these changes.

Again, finding the right buyer will fix a lot of the problems associated with seller financing. This is why sellers should never sell their business on their own. When you sell the business on your own, you do not have the ability to “interview” enough qualified buyers to buy your business. It is important to find the RIGHT buyer, not just the first buyer – or the highest offer buyer.

What kind of covenants should you be putting in place? Certainly, there is likely a covenant for every issue under the sun – and not enough room for me to cover them all here! However, typical covenants on business sales include the following:

  1. Buyer is not allowed to move the location of the business until the note is paid off.
  2. Buyer cannot sell any asset (typically over $5,000) of the business without prior permission.
  3. Buyer must maintain a set “debt to equity” ratio (meaning percentage of debt versus income). This will make sure that the business is not so overburdened that the business can’t pay its typical bills – or even you!
  4. Buyer must maintain a certain number of staff members.
  5. Buyer salary could be limited to some predetermined yearly salary and NO dividends. While this is hard to enforce, it can be a motivating factor for the buyer to pay off the loan ASAP.
  6. Buyer must provide financials or other reports on a quarterly or yearly basis.
  7. Buyer can’t sell or issue more shares or change officers of their corporation.
  8. Buyer must submit a yearly business plan to the seller. 
  9. Buyer shall maintain its books, accounts and records in accordance with generally accepted accounting principles.
  10. Buyer must maintain proper insurance like General Liability and/or the exact same type of insurance you currently have.
  11. Buyer is required to provide seller with notice of any Litigation.
  12. Buyer is required to conduct business in generally the same manner as before the sale, for  example, buyer will not change the company name or the usual types of products or services it sells.

As I mentioned, these are just a few of the covenants you could include to protect yourself. Obviously, it is best to sit down and list out the important aspects of your particular business and the areas that would harm your business if they were changed. It is also important that these items are reasonable for the buyer.

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Sigma is a the leading business broker in with Corporate offices in Dallas/Fort Worth with roots from 1984. Over 600 businesses sold in Dallas, Fort Worth, Texas, Oklahoma and across the South. Sigma provides full business brokerage services with NO upfront fees. We provide Market approach business valuations for business sales. Sigma is passionate about helping business owners achieve their goal of financial security. Contact us today for a free no obligation business valuation. We are here to help you achieve your goals.

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