Understanding Loan Covenants

Florida CFO Group partners Dan Polen, Joe Price, and Ginger Mentzer discuss loan covenants and their potential impact on your business.

Ginger: Loan covenants are fundamental to all commercial and business loans and protect the lender by making sure that the borrower fulfills conditions or prohibits the borrower from doing certain things over the life of the loan.

Joe: Typically, they are financial covenants but they can be non-financial in that you cannot do certain things such as acquire a business or have a significant member of the management team leave.

Dan: A negative covenant restricts a company from doing something, such as selling a portion of its assets, paying management fees to related parties, taking out cash distributions or purchasing certain assets. You may be able to get around these, but you must get the lender's permission before you do so.

Joe: And examples of positive covenants are having to maintain certain financial ratios and balances. A typical one is debt service ratio, where the lender wants to make sure the borrower is generating enough cash flow to fund the principal and interest for at least 12 months. Another example is working capital, which is a measure of your strength or your ability to pay bills. These are some of the positive ones from a ratio standpoint. You must maintain a net income; you cannot have losses.

Are Loan Covenants an Indication of How Lenders View the Health of My Business?

Joe: I would say more the risk of the loan. They will always want certain covenants—there are not more than three or four typically, sometimes one or two, but if they ask for more it may mean there is a little more concern or observation that the lender wants to maintain.

Dan: Loan covenants should be adaptable to the business—the bank typically wants to work with you. They are set up as markers, early warning systems that keeps the bank in touch with the health of the business so that they—they grab the patient before they are in the ICU. They have got an early warning system. They will come and they will typically want to work with you.

Ginger: Your bank is going to want quarterly financial statements; they are going to want copies of your tax returns. Depending on the collateral, you may need to maintain certain insurance policies. So companies have to make sure they monitor these things and are prepared to meet quarterly or monthly reporting requirements.

Joe: Lenders normally want third-party, CPA prepared financials and they can be a compilation or review, or a full audit depending upon what the banks needs are in a given situation. The size of the loan often determines the type of CPA report the bank wants. For example, for loans of $5M or less the lender may only require a compilation.

Ginger: Before the lender originates the loan, they make sure they have a good handle on your financial benchmarks. So the key is to make sure they do not have notable negative variances on an ongoing basis. To do this, businesses and banks create ongoing monitoring or tickler systems to make sure that nothing has changed significantly and if it has, that they know about it.

Can You Negotiate Your Loan Covenants?

Ginger: You can negotiate your loan covenants. For example, debt service might not be reasonable on an ongoing basis as opportunities for your business require you to put forward cash flow that will impact that debt service. If you help your banker understand it and they recognize the business purpose they will negotiate. There are certain things like insurance, taxes, financials that are not negotiable, but some of those other ratios and benchmarks where the mark can move can certainly be negotiated.

Joe: I would agree. But not only can you negotiate with your existing banker, you should consider interviewing several lenders to assure yourself of getting the best deal.

Dan: It's important to negotiate flexibility into your covenants. I was working with a client to secure external financing. However, they already had a loan covenant with their bank that said we could not give up over X percent without their approval. Well, in the middle of a negotiation it is a little tough to start disclosing to a banker that we are in the throes of selling ten percent or twelve percent of the business. Where we ended up was negotiating our covenants to state that if we are going to sell a significant piece of the business we would notify them.

Ginger: The number one thing for the company agreeing to the loan covenants is that they understand what they are agreeing to, as well as understand that the bank wants the loan in the best position to benefit the bank. So, if you know you are not going to be able to meet certain covenants you must not agree to them. If you do not want to have your hands tied from doing certain things with your business, you need to negotiate your covenants to reflect your plans.

Dan: And there is always a potential to carve it out. It is if you know you are going through something and the bank wants some covenant that they are very strong on and you say, alright, well we will give it to you but we need a carve-out that makes an allowance for us to go outside the covenant under these circumstances. But I agree with Ginger. If you know you are not going to be able to meet them why in the world are you going through all the grief and potential litigation to sign them to begin with.

Who Do I Need on My Team to Negotiate Loan Covenants?

Joe: Most covenants are financial in nature and you would want your CFO working in concert with the CEO. Often a personal guarantee or a PG is required in a loan agreement with a small, closely-held company and that is typically is with the owner.

Ginger: I have seen businesses go south and the guarantors had to make good. Over the last ten or 15 years banking has been real interesting and so the strength of the guarantors is significant to the loan's approval.

Dan: I agree with your CFO, CEO and I would add your general counsel if they have significant experience with your business and have been involved with loan agreements before. You need to understand that you may need to do business in a slightly different, more structured way and put new processes and procedures in place.

How do I Monitor Loan Covenants?

Ginger: Normally you use financial statements and you need to make sure that you are computing the financial ratios required by your covenants as part of your ongoing financial process. As an example, some loans are going to be secured by receivables, so you must compute the percentage of your receivables you can draw on. You are going to want to make sure you can compute those things on an ongoing basis and that they are very accurate. So, you just build it into your processes.

Joe: As Ginger said, most covenants are tied to financials so build them into your financial reporting. If they are non-financial in nature it is just part of running your business and knowing what you can do and what you cannot do. With good management, good management systems, and good financial systems reporting in place, you just make it part of the regular routine of your normal monthly, quarterly and annual processing.

Dan: And it is communication. I mean it comes down to making sure that people who need to know keep track of covenant performance. But sometimes over time or through a transition if these things are not communicated and the bank is not on top of it, it can be a rude surprise if you do not have it tracked and documented.

Ginger: And the banks do have some tools too to monitor certain things, such as payment of taxes and maintenance of insurance policies and so forth. So, for those things that are simple for them to track, say if you fall behind on your insurance policies they will force-place the insurance. They will give you an opportunity to cure it but if you do not, they will make sure the coverage is in place and it will cost you a whole lot more than if you would have just maintained it on your own.

What Should I Do If I Breach My Loan Covenants?

Joe: Communication is the key thing. Your lender should typically be a trusted advisor. You should be on a first name basis with your banker and already have a good relationship. Unless something unusual or severe happens, a breach should not be surprise. Timely reporting and communication between borrower and lender should give each a good feel for the company's ability to meet its covenants. The only thing worse than bad news is delayed bad news. The banks do not want to call in your loan, they want to work with you and so you are better off to tell them ahead of time and seek their counsel. Your lender has seen companies in your situation scores of times before and while they might lead you to make some tough decisions, they want you to survive. So again, communication, timely communication is key.

Ginger: I would totally agree and in discussing it with your lender, you have got to have a plan when you call them. If you know you are going to breach a covenant you need to come up with a plan that can help you to get into compliance so that way, the bank is not going to force your hand in telling you what to do.

Dan: And I would say it's important to have dates on your plan. Communicate it: I have a plan and here what we're going to do and when we are going to do it. That way when your banker goes back to their loan committee they can say, look this is what their plan is, this is where they are off and this is what they have done.

Ginger: So yes, timely communication. The bank can call the loan if they must, but as Joe said, they will give you a short time to remedy the breach. The best thing is to come up with a plan, for example, it might require some changes to executive compensation, require you to put up additional collateral, or renegotiate contracts with service providers that are working with you. I have been in a situation where a nonprofit has had to renegotiate their agreements with their national organization and reduce their annual financial contribution as part of their workout. You are going to have to see what you can give up before you are asking the bank to do so.

Joe: For the lender it comes back to basics: does the company have a successful business model? All companies go up and down with business cycles and some run into trouble -- is it just a temporary thing?

Ginger: The bank is concerned if this a temporary blip or is this an ongoing problem. You should sharpen your pencil and see what you can do to try to improve the situation at the company. So you're planning for certain things to happen and then all of the sudden the market turns and you are not going to be able to meet your plan -- what are you going to do?

This is where an experienced group like ours can help. We can help with disaster planning, identify options and look for ways for a client to get back into compliance. We can work the bank to come up with a short-term modification agreement and help the company with the decision making to execute changes.

Joe: It is not unusual to get what is called a waiver letter from the lender. It really helps if the lender is familiar with your company, knows the management team well and has been informed on a quarterly basis. I think they look to the character of the ownership and the management. That carries a lot of weight.

As a last resort, your lender may transfer your company to their special assets department where you will really be under the microscope. They will be your shadow for a long time, staying very to the business. They may bring in some people or require that the company bring in people versed in this kind of a workout because there are tough calls that need to be made on compensation, on manpower, if you need a reduction in force, etc. Sometimes owners that have not been through the process are slow to cut expenses. The bank can get aggressive in terms of telling you what to do and as Ginger mentioned they have a promise from you to pay and they have certain rights that go along with that so they can force your hand on certain things.

Final Thoughts on Loan Covenants

Joe: Loan covenants are negotiable between lenders and to a lesser degree within an individual lender. Make sure you are comfortable with your ability to meet them. You are getting a loan from a bank and making a commitment to honor a debt obligation with covenants that should help make repayment easier. When covenants are worked out fairly, above board, and with a good understanding of the business, most of them work out fine. But when they do not, upfront communication with a workout plan may still save the day.

Ginger: Loan covenants require you to fulfill certain conditions and prohibit you from taking certain actions, so you have got to make sure you know what you are agreeing to upfront. For less experienced companies, financial loan covenants do make sense. They should be concerned, they should be knowledgeable of these covenants and why they are important. They might not think so initially, but some of these covenants help them to manage their own business.

Dan: Many of the businesses we help are growing from initial products and services with a founder and small staff and five to ten million dollars of revenue to much more complex businesses generating $20 to $50 million annually. They require loans to fuel their growth and it's important that they form a strong working relationship with a lender that becomes knowledgeable about their business. The loan covenants will reflect the effort the management team puts into selecting and educating their lender to their industry and the business. Loan covenants can, and should be adaptable to your business. 

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