A Bank's Working Capital Demand Nearly Sank Three Buyers

The situation

Four days before the scheduled closing, the bank's commitment letter arrived with a term nobody had discussed in any of the earlier calls: a covenant requiring the business to maintain a fixed minimum level of working capital at all times, tested monthly, starting the day the loan funded. Edgardo read it twice before he understood what it actually meant. The number the bank wanted held in reserve was more than the business, as it operated, ever kept on hand.

Edgardo, Bikash, and Sunita had worked together for years at a small Kitchener business, watching the founder near retirement with no obvious succession plan. Edgardo was a college student finishing his degree part-time while working at the business, Bikash worked as an administrative assistant elsewhere but had grown up around the shop, and Sunita had been there longest of the three. When the founder finally decided to sell, the three of them pooled savings, brought in a modest bank loan to cover the balance, and agreed to buy the business together rather than see it sold to an outside buyer who might close it down or relocate it.

The purchase price sat in the lower range for a business of this kind, and the loan the bank offered was structured as a term loan secured against the business's assets, with the founder agreeing to hold back a portion of the price as a seller note to bridge the gap between what the bank would lend and what the deal required. That structure is common for employee buyouts of small businesses, where the buyers often have limited personal capital and the bank wants the seller to retain some financial stake in the business succeeding after closing.

Before the bank's commitment letter arrived with the working capital covenant attached, Edgardo's uncle, who had run a small business himself decades earlier, had reviewed an early draft of the loan terms and told the three of them not to worry, that banks always ask for more than they need and it would sort itself out at closing. Relying on that reassurance, none of them pushed back on the covenant when it first appeared in a preliminary term sheet, and by the time the final letter confirmed the number was not moving on its own, closing was days away.

The legal question

A working capital covenant is a promise, written into the loan agreement, that the borrower will maintain a minimum level of current assets over current liabilities at all times the loan is outstanding. Banks use these covenants to protect themselves against a borrower running the business too close to the edge, since a business that runs out of operating cash can miss loan payments even while it is otherwise profitable on paper.

The legal question was not whether the bank could impose a covenant like this. It plainly could, as a condition of extending credit, and the loan agreement gave the bank real remedies, including calling the loan due immediately, if the covenant was breached. The question was whether the specific number the bank had set was workable for this particular business, given its actual seasonal cash flow, and whether the covenant as drafted measured working capital in a way that fairly reflected how the business really operated.

The business's cash position moved significantly through the year, with slower months where receivables outpaced cash in hand and busier months where the reverse was true. A covenant tested monthly against a single fixed minimum number did not account for that seasonality at all. If the number was set based on the business's strongest months, as the bank's initial draft appeared to be, the business would technically breach the covenant during its own ordinary slow periods, through no mismanagement by the new owners at all.

There was a second legal question underneath the first: what counted as working capital for purposes of the test. The draft definition in the bank's commitment letter included the full seller note as a current liability, which inflated the deficit the covenant was measuring against, even though the seller had agreed to subordinate that note and had no intention of demanding repayment on the schedule a strict reading implied. Whether the bank would agree to exclude or subordinate that note within the covenant's own definition was as important as the headline dollar figure, and it was not something the buyers, none of whom had negotiated a commercial loan before, had any way to know to ask about.

Underneath both questions sat a practical one that mattered just as much to the three buyers as the legal analysis: what actually happens if the covenant is breached. The loan agreement gave the bank the right to accelerate repayment or restrict further advances on a breach, remedies that exist to protect the lender but that can be devastating to a small business with no financial cushion to absorb them. Understanding that a technical, one-month dip below a badly calibrated minimum could trigger the same remedies as genuine financial distress was what turned this from a drafting quibble into something worth fighting over before closing.

What we did

1. Reviewed the commitment letter's covenant language line by line. We identified that the working capital definition treated the seller's subordinated note as a current liability, which was the single largest driver of the covenant appearing unworkable, and flagged this as the clearest point to raise with the bank's commercial lending officer. Leading with the clearest, most defensible error gave the bank an easy first concession that built momentum for the larger renegotiation ahead.
2. Modelled the business's actual monthly cash position against the covenant as drafted. Using financial statements from the past several years, we showed month by month where the business would have breached the fixed minimum under ordinary seasonal conditions, which turned an abstract objection into a concrete demonstration the bank's own underwriter could not easily dismiss. We built the model using the same accounting categories the bank's own covenant relied on, so the comparison could not be waved away as measuring something different.
3. Corrected the misunderstanding left by the uncle's earlier advice. We explained plainly to Edgardo, Bikash, and Sunita why a bank's initial covenant terms do not simply soften on their own without someone actively negotiating them, so the three of them stopped waiting for the number to move and gave us clear authority to negotiate before the closing date arrived. That authority mattered, since every day spent hoping the bank would soften on its own brought the closing date closer.
4. Proposed excluding the subordinated seller note from the working capital calculation. Since the founder had agreed not to demand repayment ahead of the bank, we argued the note should not count as a current liability for covenant purposes, and provided draft language subordinating it explicitly within the loan documents rather than leaving that intention implied. Making the subordination explicit in writing closed off any later argument that the note still counted as a liability under a strict reading.
5. Negotiated a seasonally adjusted minimum in place of a single fixed number. Rather than one figure tested every month regardless of season, we proposed a minimum that stepped down during the business's known slower months and stepped back up during its stronger ones, matching the covenant to how the business actually generated and used cash. We based the seasonal steps on three years of monthly statements, so the bank could see the adjustment reflected this business's cycle, not a template argument.
6. Coordinated directly with the bank's lending officer and legal counsel. We held two calls in the days before closing to walk through the modelling and the proposed language, which let the bank's own risk team sign off on a revised structure quickly rather than restarting underwriting from scratch. Speaking directly with both the lending officer and counsel avoided the delay of relaying language back and forth.
7. Documented the revised covenant in an amended commitment letter. We confirmed the final terms in writing before funds were released, including the seasonal adjustment and the note exclusion, so the buyers closed with covenant terms the business could realistically meet. We also confirmed the amended letter fully superseded the earlier draft, so no ambiguity remained about which version governed the loan.
8. Walked the three buyers through what breach would actually mean. Beyond negotiating the number itself, we explained plainly what the bank's remedies for a covenant breach would look like in practice, so Edgardo, Bikash, and Sunita understood exactly what they were protecting themselves against and could weigh the trade-off of a larger cash cushion against that risk with clear eyes rather than in the abstract.

The outcome

The bank agreed to exclude the subordinated seller note from the working capital calculation and accepted a seasonally adjusted minimum in place of the original fixed figure. The revised number was still higher than Edgardo, Bikash, and Sunita would have preferred going into their first year of ownership, and it meant holding back a larger cash cushion than they had originally budgeted for, in the low tens of thousands, money that could not go toward equipment upgrades or a marketing push they had hoped to make early on.

The deal closed on schedule, four days after the amended commitment letter was signed, without needing an extension to the closing date that could have put the entire purchase at risk if the founder had grown impatient or found another buyer willing to move faster. The three new owners started the business with a covenant they could actually live with month to month, rather than one that risked a technical default the first time a slow season arrived.

It was not a complete win. The buyers gave up flexibility they had wanted, and the cash cushion the revised covenant required limited what they could spend in their first year, a real cost they carried into ownership. But it avoided the alternative, which was either walking away from a deal they had worked toward for months or closing under terms nearly certain to put them in breach within two quarters, letting the bank call the loan due at the worst possible time.

Edgardo, Bikash, and Sunita spent their first year deliberately building the working capital reserve toward the higher figure the revised covenant required, treating it less as a burden and more as a discipline that matched how a lender expected the business to be run. A year in, none of the three regretted the tighter number, even though it cost them flexibility they had hoped to have starting out.

What you can learn from this