Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Loan Covenant Trap That Cost a Seller 22 Million
Transcript
- Lucas: So Luna, we've spent a lot of episodes on the traps that bite at closing or in the negotiation. But today I want to talk about a trap that went off six months after the deal closed. The seller walked away thinking they were done, and then the buyer's lender came knocking. Luna: Six months after closing? That sounds like a post-closing covenant. Who knew the buyer's credit agreement could reach back and hurt the seller? Lucas: Exactly. And this one cost the seller 22 million dollars. The deal itself was a classic private equity-backed acquisition. Mid-sized manufacturer, EBITDA around 40 million, sold for 320 million. The seller took a chunk in cash, plus an earnout tied to hitting a 45 million EBITDA target in the first year after closing. Luna: So the earnout was already a source of tension. But the loan covenant made it worse, I'm guessing. Lucas: Right. The buyer financed the deal with a mix of equity and debt, and their credit agreement included a financial covenant that required the acquired business to maintain a minimum EBITDA of 40 million on a trailing twelve-month basis, tested quarterly. Now, the seller was not a party to that credit agreement. They had no idea about the specific covenant terms. But here's the kicker: the purchase agreement included a representation that the business would not undergo a material adverse change, and it also had a post-closing covenant that said the seller would cooperate with the buyer's financing arrangements. Luna: So the seller signed a cooperation clause, and that gave the buyer leverage when things went south. Lucas: Precisely. Six months in, the business hit a rough patch. A big customer delayed orders, and the trailing twelve-month EBITDA dipped to 38 million. That triggered a breach of the loan covenant. The lender didn't call the loan immediately, but they tightened the terms and demanded a higher interest rate and a fee. The buyer, in turn, came back to the seller and said, you breached your representation about no material adverse change, and you failed to cooperate with our financing by not maintaining the EBITDA level that the lender required. Luna: That seems like a stretch. The seller didn't control the customer's order delays. But in a legal sense, they were on the hook for that representation, right? Lucas: That's exactly the problem. The purchase agreement's definition of material adverse change was broad, and it didn't carve out industry downturns or customer-specific issues. The seller's lawyers tried to argue that the customer delay wasn't a MAC, but the buyer pointed to the precise language: any event that has a material adverse effect on the business, financial condition, or results of operations. And the EBITDA dip was right there in black and white. Luna: So the seller was forced into arbitration or litigation to defend that, which costs time and money. But the 22 million loss — how did that come about? Lucas: The seller had to settle. The buyer threatened to sue for breach of representation and to claw back part of the purchase price. The seller's only leverage was the earnout, which was still unpaid. In the end, they agreed to forfeit the entire earnout, which was worth 18 million, and they paid a 4 million settlement to cover the lender's fee and the buyer's legal costs. Total hit: 22 million. Luna: That's brutal. But what could the seller have done differently? I mean, you can't control the buyer's financing terms, right? Lucas: You can't control them, but you can understand them before you sign. This seller never asked to see the buyer's credit agreement. They didn't know that the covenant existed. And the cooperation clause was broad enough to be a trap. A good seller's lawyer would have insisted on a provision that said the seller's cooperation is only required to the extent it doesn't cause the seller to breach any representation or warranty. And more importantly, they would have added a materiality qualifier to the MAC representation — something like, 'other than changes generally affecting the industry or the economy, or changes resulting from the buyer's actions or the seller's compliance with the purchase agreement.' Luna: So a materiality qualifier would have carved out industry downturns. But what about the loan covenant itself? Could the seller have asked for a covenant look-back period or something? Lucas: Absolutely. The seller could have negotiated a provision in the purchase agreement that says the buyer's financing arrangements cannot impose any obligations on the seller beyond those explicitly set forth in the purchase agreement. And the seller could have required that the buyer obtain a waiver or amendment from the lender before the seller is deemed to be in breach. In this case, the buyer could have gone to the lender and said, 'the shortfall is temporary, we're willing to put in more equity,' but they chose to use it as leverage against the seller instead. Luna: So the real lesson is that the seller should have tied their cooperation to the buyer's actual financing documents and put the risk of a covenant breach on the buyer. Lucas: Exactly. And there's one more thing: the earnout. The earnout definition tied the EBITDA target to the same trailing twelve-month calculation as the loan covenant. So when EBITDA dipped for covenant purposes, it also meant the earnout wasn't met. The seller was hit twice by the same number. Luna: That's a nasty double whammy. And I'm guessing the seller didn't have any cure rights either. Lucas: No cure right at all. The purchase agreement said the earnout is forfeited if the target isn't met, period. There was no provision for a temporary shortfall or a make-up period. If they had negotiated a cure right — say, the seller gets nine months to make up the shortfall — they could have avoided the whole mess. But they didn't think about it because they were focused on the closing price, not the post-closing risks. Luna: Speaking of focusing on the closing price — that reminds me of something. You know, these conversations about the nuances of deal-making, they're exactly why we keep this show ad-free. And if this kind of analysis has been useful to you in your own work, there's a small way to keep it going. Lucas: Yeah, it's a low-key thing. If today's episode was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It helps us keep the lights on and the podcast free for everyone. Luna: No pressure at all. We're just glad you're here. Anyway, back to the covenant trap. So the seller could have also asked for a cap on their liability for any post-closing covenants, right? Lucas: Yes, a liability cap is another protection. In this deal, the seller's total liability under the purchase agreement was capped at 20 percent of the purchase price, but that didn't help because the earnout forfeiture wasn't counted as a liability — it was just a failure to earn. And the settlement payment was within the cap, so it didn't provide any real protection. Luna: So the cap was essentially useless in this scenario. What about the seller's insurance? Did they have reps and warranties insurance? Lucas: They did, but it didn't cover this. The policy had a specific exclusion for any loss arising from the buyer's financing arrangements. That's becoming more common in the insurance market, so sellers need to read those exclusions carefully. Luna: So even the insurance didn't save them. This is a classic case of the seller not thinking about the buyer's financing structure. In today's environment, with interest rates still elevated and lenders being more hawkish, this kind of risk is growing. Lucas: Absolutely. As of late August 2026, we're seeing more covenants in credit agreements, and lenders are less willing to grant waivers. Sellers need to assume that any EBITDA miss could trigger a covenant breach, and they should structure their deal accordingly. Luna: What are some practical steps a seller can take early in the process to avoid this? Lucas: First, ask the buyer about their financing plans early. If it's a leveraged buyout, get a summary of the key terms of the credit agreement, especially any financial covenants. Second, make sure the purchase agreement explicitly states that the seller's cooperation is limited and that the buyer bears the risk of its own financing. Third, negotiate a materiality qualifier in the MAC clause. And fourth, consider a cure right for the earnout, with a reasonable look-back period. Luna: And also, maybe the seller should have a provision that says if the buyer's lender imposes new conditions, the seller has the right to approve them before they become binding. Lucas: That's a great point. A consent right over any amendments to the buyer's financing that could affect the seller. Some sellers even go so far as to require that the buyer obtain a waiver from the lender before the seller can be deemed in breach. That puts the burden on the buyer to manage its own lender relationship. Luna: In this case, the buyer didn't even try to get a waiver. They just used the breach as leverage to renegotiate the deal in their favor. Lucas: Right. And that's the ugly side of M&A. Once the deal closes, the power dynamics shift. The buyer has the seller's money, and the seller is often left without much recourse. So the time to protect yourself is before you sign. Luna: One more thing — the seller could have asked for a post-closing adjustment mechanism that would have accounted for the EBITDA shortfall. Instead of a binary earnout, maybe a sliding scale. Lucas: That's actually a really constructive idea. A sliding-scale earnout would have reduced the payout based on actual performance, but it wouldn't have been a cliff. The seller would have received something for the 38 million EBITDA, even if it wasn't the full 18 million. That would have softened the blow. Luna: So instead of an all-or-nothing earnout, they could have had a partial payout. That seems more fair. Lucas: It is, but it's also more complex to negotiate. Some sellers prefer the binary because it's simple, but they don't realize how risky it is. This case shows that a one-time miss can wipe out the entire earnout, and that's a big risk. Luna: And the fact that the loan covenant and the earnout were tied to the same EBITDA number made it even more dangerous. Lucas: Exactly. The seller should have insisted that the earnout be based on a different metric, or at least that the covenant be tested on a different basis. But they didn't, and it cost them 22 million. Luna: So for any operator listening who's thinking about selling, what's the one thing to take away? Lucas: Before you sign, ask to see the buyer's credit agreement. If they won't show it to you, that's a red flag. You need to know what covenants the lender is imposing on the business you're selling, because those covenants can become your problem after closing. Luna: And if they won't share it, you might want to walk away. Lucas: Or at least adjust your price to reflect the risk. Because in this environment, with lenders as strict as they are, that covenant risk is real. It's not a hypothetical. It's happening.