Seller's note protections for cash flow-based hurdles

July 24, 2024

by a searcher from University of Florida in Chapel Hill, NC, USA

I am working on a deal where there is a hurdle for a seller's note. The seller would like the hurdle to be based on revenue. For example, some of the seller's note payment would not be due if the revenue for the company fell below $3,000,000.

The bank needs the hurdle to be based on cash flow. This is because the margin has fluctuated over the last several years and to meet DSCR requirements for the lowest-margin year, the business would need to hit revenue targets it has never hit before.

The seller is understandably concerned that cash flow can be manipulated by increasing expenses. Does anyone have examples of guardrails that can help assuage the seller's concerns?

Reply by a professional
in Crystal Bay, NV, USA

In our experience, the seller needs to get payment based on EBTDA versus Gross Revenue to be compliant with lender requirements. That said, there can be a two tier trigger if EBITDA exceeds $XX and Revenue exceeds $YY, then borrower would pay some agreed upon accelrated payment.

Reply by a lender
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA

I have seen deals done based on revenues, but usually the lender still requires some sort of clause in the note that you can only make the payment so long as the cash flow is present to do so at a certain minimum level. This is the only way the Bank can protect their first position. In addition, you should want this in there as well. What if revenues increase but due to whatever market condition, your margins get compressed. You may have the revenue but not the cash flow to pay on the note. You should not have to pay on the note in that situation.

What I have seen agreed to in other deals is that an accounting firm is assigned to verify the adjusted EBITDA or the cash flow for making the payment. That way the seller knows a third party has reviewed it. You can even define what is included in the adjusted EBITDA.

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