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 are providing seller financing, 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.
What is a Covenant?
In a seller financing arrangement with a covenant, the buyer is required to meet certain obligations or restrictions as part of the financing agreement. The purpose of the covenant is to protect the interests of the seller by ensuring that the buyer continues to operate the business in a manner that is consistent with the seller’s expectations and intentions.
Common examples of covenants in seller financing agreements include restrictions on the buyer’s ability to sell the business, make major changes to the business, or incur additional debt without the seller’s approval. The covenants may also require the buyer to maintain certain financial ratios or performance metrics, such as revenue or profits, during the financing period.
If the buyer fails to meet the obligations or restrictions set forth in the covenant, the seller may have the right to take action to enforce the covenant, such as withholding payments, imposing penalties, or even repossessing the business.
Protect Your Business With Covenant Provisions
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.
What are the Types of Seller Financing Covenants Available?
There are several types of covenants that can be included in a seller financing agreement. These covenants can be categorized into two main types: affirmative covenants and negative covenants.
- Affirmative covenants: These are promises made by the borrower to take specific actions or meet certain obligations during the financing period. Common examples of affirmative covenants include:
- Maintain financial records and provide regular financial statements to the lender
- Make timely payments of principal and interest
- Maintain insurance coverage on the property or business
- Comply with all applicable laws and regulations
- Use the funds for the intended purpose as specified in the financing agreement
- Negative covenants: These are promises made by the borrower to refrain from taking certain actions or engaging in specific activities during the financing period. Common examples of negative covenants include:
- Restricting the borrower’s ability to take on additional debt
- Limiting the borrower’s ability to dispose of or sell the assets that are being used as collateral
- Preventing the borrower from entering into contracts or agreements that could adversely affect the borrower’s ability to repay the loan
- Prohibiting the borrower from making major changes to the business or the property without the lender’s approval
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.
Examples of Seller Financing Covenants
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:
- Buyer is not allowed to move the location of the business until the note is paid off.
- Buyer cannot sell any asset (typically over $5,000) of the business without prior permission.
- 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!
- Buyer must maintain a certain number of staff members.
- 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.
- Buyer must provide financials or other reports on a quarterly or yearly basis.
- Buyer can’t sell or issue more shares or change officers of their corporation.
- Buyer must submit a yearly business plan to the seller.
- Buyer shall maintain its books, accounts and records in accordance with generally accepted accounting principles.
- Buyer must maintain proper insurance like General Liability and/or the exact same type of insurance you currently have.
- Buyer is required to provide seller with notice of any Litigation.
- 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.
Scot Cockroft is the Owner & President of the #1 ranked Business Brokerage, Business sales and M&A firm in Texas. Scot has been named Named Deal Maker of the Year by Dallas Business Journal.
He is committed to a “different” type of business brokerage firm, one that is NOT about a sales pitch but, rather, results! In short, a business brokerage firm that is committed to performance-based compensation. Scot believes in these principles as well as a candid honesty with clients. His candid style often takes buyers and sellers by surprise, but is often what assures successful connections between the two.
Feel free to reach out!