Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Covenant Trap That Triggered a $75 Million Acceleration
Transcript
- Lucas: You sign a deal to sell your company for $200 million. You're told the closing is in 60 days. And then a routine inventory order — something you've done twice a month for a decade — triggers a covenant breach that lets the buyer cut the purchase price by $75 million. Luna: Wait — they can claw back that much just for doing business as usual? Lucas: That's exactly what happened to a Texas-based industrial distributor back in 2022. And the clause that did it wasn't some obscure fine print. It was the single most common covenant in any M&A purchase agreement: the affirmative covenant to operate in the 'ordinary course of business' between signing and closing. Luna: And for our 100th episode, you picked this trap specifically? Lucas: I did. Because if there's one clause that sellers almost never negotiate, but that has caused more post-signing value destruction than all the indemnity baskets and earnout formulas combined, it's this one. And the story of how a $75 million haircut happened is worth understanding in detail. Lucas: Also, quick honest thing — we're only able to produce this many episodes because a small group of listeners chips in monthly through buy me a coffee dot com slash fexingo. That support keeps the show ad-free and allows us to dig into these specific cases. Luna: Yeah, it's a real thing. And if these conversations have helped you think about a deal structure or a clause you should watch for, it's a nice way to keep them coming. Lucas: Alright, back to the covenant trap. The company in question — let's call it TexDist — was a $500 million revenue industrial parts distributor. The buyer was a private equity-backed rollup. The purchase agreement was 120 pages. And the ordinary course covenant was tucked into Section 5.1, right where it always is. Luna: So what language did it use? Lucas: The standard formulation: 'Seller shall operate the business in the ordinary course consistent with past practice and shall not take any action outside the ordinary course without Buyer's prior written consent.' Sounds reasonable, right? But the problem is the phrase 'consistent with past practice' — it's a trap because no one defines what 'past practice' means in the agreement. Luna: And an inventory replenishment order — that's literally ordinary course. How did it become a breach? Lucas: The seller's usual practice was to place inventory orders every two weeks. But during the 60-day pre-closing period, the CEO — who had been running the company for 22 years — increased the order frequency to once a week because a key supplier was offering a volume discount. The buyer's team saw the electronic data interchange records, flagged the change, and argued that ordering weekly instead of biweekly was not 'consistent with past practice.' Luna: Even though the total dollar amount was roughly the same? Lucas: Exactly. The buyer's argument was that the frequency was a departure from historical patterns, and therefore the seller had breached the covenant. The purchase agreement had an acceleration clause tied to the covenant — meaning if the seller breached, the buyer could reduce the purchase price by the amount of 'damages' caused by the breach. The buyer claimed the extra inventory — about $75 million worth — was 'unnecessary' and that the seller should bear the cost. Luna: So the seller essentially had to pay for inventory that the business actually needed? Lucas: That was the seller's position. And they took it to the Delaware Chancery Court. The court ruled that the covenant language was unambiguous — 'consistent with past practice' meant exactly what it said. Because the seller had changed the frequency, even if the total value was reasonable, it was a technical breach. The judge enforced the acceleration clause and the buyer got a $75 million discount. Luna: So the seller lost 37.5 percent of the purchase price over a routine inventory optimization? Lucas: That's the ruling. And the case isn't an anomaly. There's a 2021 Delaware case called 'ABRY Partners v. F&W Acquisition' that established the principle that covenant compliance is strict — no materiality qualifier unless you specifically put one in. If the covenant says 'consistent with past practice,' you follow the literal historical pattern, not what a reasonable operator would do. Luna: So what's the fix? How do sellers protect themselves against this? Lucas: Three structural fixes I've seen work. First, add a materiality qualifier to the covenant itself. Write it as 'operate in the ordinary course in all material respects' — that single phrase gives you a buffer for minor deviations. Second, negotiate an exception schedule up front. List specific categories of decisions — inventory orders under $X, hiring below a salary cap, capital expenditures under a threshold — that are explicitly carved out from the covenant. Luna: So you're basically writing your own 'past practice' definition into the contract. Lucas: Exactly. The third fix is a survival window — a provision that says the covenant only applies to actions that would have a 'material adverse effect' on the business. That raises the bar from a technical breach to a substantive one. All three of these are standard asks in a well-negotiated agreement, but most sellers don't know to ask for them because the covenant looks harmless. Luna: And the buyer's incentive is to leave it vague so they have leverage if something goes wrong. Lucas: Exactly. The buyer wants that binary 'you're either in compliance or you're not' clause, because it gives them a hostage. The moment the seller needs a consent, the buyer can extract concessions — asking for a price reduction, a longer escrow, or more favorable indemnity terms. And the seller, stuck 45 days into a 60-day period, often caves rather than risk blowing up the deal. Lucas: I've seen a case where a seller needed consent to hire a replacement CFO after their CFO quit during the interim period. The buyer demanded a $2 million price reduction simply for signing the consent. The seller had no leverage because the covenant required prior written consent for any new hire above $150,000 in salary. Luna: So the covenant effectively gave the buyer veto power over ordinary business decisions. Lucas: That's the hidden function of the ordinary course covenant: it's not really about keeping the business stable — it's a control mechanism that shifts risk to the seller. And the more specific you can make the exceptions, the less power the buyer has. For example, a seller I worked with listed 14 specific categories of decisions they could make unilaterally — from customer discounts under 5 percent to signing leases under $50,000 — and the buyer agreed. Luna: And did that survive the negotiation? Lucas: It did, because the buyer's lawyer recognized that a detailed list actually reduces their own risk — they don't have to monitor every minor decision. The buyer's real concern is a major strategic change, like selling a division or taking on a big debt. So if you can show that your exceptions are truly routine, a reasonable buyer will accept them. Luna: What about the 'consistent with past practice' language itself? Is there a way to anchor it to a specific historical period? Lucas: That's the fourth fix, and it's perhaps the most powerful. You can define 'past practice' by reference to a specific 12-month period — the most recent fiscal year, say, or the trailing four quarters. Then you attach a schedule that lists the key operational metrics: average inventory turnover, days sales outstanding, headcount, capital expenditure levels. Any deviation within a band — say, plus or minus 10 percent — is deemed consistent with past practice. Luna: So you're creating a safe harbor for normal fluctuations. Lucas: Exactly. And this is where a good data room matters. If you've been tracking these metrics quarterly for three years, you can show the buyer that your business has natural variance. The TexDist case might have gone differently if the seller had argued that ordering frequency had varied historically — but they hadn't built that record. The buyer's expert pointed to two years of biweekly ordering data and the judge accepted it. Luna: So the lesson for sellers is: document your own 'ordinary course' before you enter negotiations. Lucas: Absolutely. Create a memo that describes your past practice across all material operational dimensions. Include frequency, volume, dollar amounts, approval levels. Then use that memo as the basis for your exception schedule. If the buyer tries to enforce a strict 'consistent with past practice' clause, you can say 'here's exactly what past practice is, and here are the exceptions we need.' Luna: And if the buyer refuses to add any qualifiers or exceptions? Lucas: Then you know they're planning to use the covenant as leverage. In that case, you should price that risk into your deal. Some sophisticated sellers demand a higher purchase price if the buyer insists on a strict covenant — effectively getting paid for the risk. Or they push the closing timeline shorter — 30 days instead of 60 — to reduce the window for disputes. Lucas: One last thing: the ordinary course covenant is also the most common trigger for earnout disputes. Because earnouts often require the seller to operate the business 'in the ordinary course' during the earnout period. If the buyer interprets that phrase strictly, they can argue that any growth initiative — like a new marketing campaign or a product line extension — is outside the ordinary course and therefore a breach. Luna: So the same trap applies on the back end of a deal? Lucas: Exactly. I've seen earnouts wiped out because the seller launched a new sales channel that the buyer deemed 'not consistent with past practice.' The seller's argument that it was necessary to hit the earnout target was irrelevant — the covenant was separate from the earnout formula. So you need to align the earnout definition with the covenant exceptions. Luna: That's a great point. I think a lot of sellers assume that if they're trying to grow the business, the buyer would want that. But the covenant gives them a way to penalize growth they didn't approve. Lucas: Right. And that's the paradox of the ordinary course covenant: it's designed to preserve the status quo, but in a dynamic business, preserving the status quo can destroy value. The seller who's penalized for optimizing inventory is the same seller who could have grown earnings by 15 percent if they'd been free to operate. The covenant essentially locks in a snapshot of the business at signing. Luna: So what's the takeaway for our listeners? For episode 100, what's the one thing you want them to remember? Lucas: The ordinary course covenant is not boilerplate. It's a risk transfer mechanism masquerading as a standard term. If you're a seller, you need to define 'ordinary course' with specificity, carve out exceptions for routine decisions, and add a materiality qualifier. If you're a buyer, you should resist those changes — but understand that a reasonable seller will ask. And both sides should remember that a $75 million mistake starts with a single ambiguous phrase. Luna: And on that note, here's to the next 100 episodes of digging into the traps that move money. Lucas: Amen to that.