Financial health indicators & solvency — leverage, reserves, covenants.

Verbal assurances of wealth ("we have the capital") have zero value in this audit. Demand documented proof through financial metrics. Senior lenders always get paid first in any liquidity crunch — this is contractual law, not buyer discretion — so a leverage profile that constrains cash flow constrains your earnout regardless of buyer intent.

§ 01 · Leverage ratios — the safety thresholdDebt-to-EBITDA as primary metric.

Request the buyer's current platform Debt-to-EBITDA ratio with supporting documentation from a redacted credit-facility document or a compliance certificate. The ratio determines whether cash flow will be available for earnout payments.

Safe Zone (below 4×): conservative capital structure with significant financial flexibility. The buyer can absorb operational challenges without threatening earnings or earnout obligations. PE platforms targeting the competitive band (10–12×) typically operate here.

Moderate Zone (5×): standard for many PE platforms. Manageable but requires monitoring for covenant compliance. Less room for error. If operational performance deteriorates, the buyer may begin constraining investments or distributions.

Critical Risk Zone (above 6×): a High Severity red flag. The buyer is highly sensitive to interest-rate fluctuations, market downturns, and operational missteps. A "Critical" threshold of 7× suggests the buyer may struggle with basic debt service, let alone earnout obligations. Any deterioration creates immediate covenant breach risk.

Mitigation if leverage exceeds 6×: negotiate a higher percentage of cash-at-close (reducing earnout exposure), demand earnout payments be held in a secure Escrow Account, request specific carve-outs in the credit facility that protect earnout payments from covenant-driven restrictions, or consider a shorter earnout period (2 years instead of 3) to reduce extended leverage exposure.

§ 02 · Capital reserves — post-close investment capacityDry Powder, not last dollar.

A buyer who spends their last dollar to acquire the agency has no fuel left to run it. Post-close investment capacity directly determines whether the buyer can fund operational growth and weather unexpected challenges.

Verification: for PE buyers, verify Uncalled Capital — funds Limited Partners are contractually obligated to provide but have not yet been invested. Request the fund's Capital Call Schedule or a letter from the sponsor confirming uncalled commitments. For Strategic buyers, request recent financial statements (Q3 or Q4) showing liquid assets, available credit lines, and cash position. Cross-reference against leverage ratios to confirm reserve capacity is real, not theoretical.

Crisis capacity question: "If we lose a major account next month, do you have the cash reserves to weather it without cutting staff or reducing operational investment?" A lack of reserves means the financial risk of the transition shifts entirely onto the seller, who bears earnout performance risk while the buyer controls the levers. Undercapitalized buyers are statistically more likely to cut costs aggressively post-close — manifesting as "synergy" layoffs that damage agency culture and disrupt client relationships.

§ 03 · Credit facility covenants — earnout payment restrictionsThe contractual trap.

Even if a buyer wants to pay an earnout, their loan agreement may legally prohibit it. Many credit facilities contain Restricted Payment covenants that automatically freeze "junior" payments (including seller earnouts and subordinated notes) if the buyer's leverage ratio breaches a specific cap — commonly 6.5× or higher.

The trap in action: the seller could hit all performance targets and earn 100% of the earnout. But if the buyer's entire platform underperforms and the consolidated leverage ratio breaches the covenant, the seller's payment is legally blocked. This is not a breach of the earnout agreement — it is a breach of the credit-facility covenant that supersedes the earnout. Cross-Default Risk is particularly dangerous: the seller's agency could perform perfectly, but losses in the buyer's other portfolio companies trigger a covenant breach that prevents payment.

Covenant audit requirements: request a copy of the senior credit-facility agreement (redacted for other borrowers' terms). Identify the specific restricted-payment covenant and threshold. Determine whether earnout payments are explicitly carved out or subject to restriction. Map the covenant threshold against the buyer's current leverage to assess buffer distance.

Maturity risk: review the Debt Maturity Schedule. If the buyer's main credit facility expires or requires refinancing during the seller's 3-year earnout period, there is significant risk that refinancing difficulties drain cash flow or lead to stricter covenants that imperil future payments. Refinancing often occurs in adverse market conditions (rising rates, tightening credit) — creating a cascade: higher debt costs reduce available cash, stricter covenants restrict discretionary payments, the seller's earnout becomes collateral damage. Request a debt-maturity schedule that extends beyond the earnout period.

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