So your business wants to borrow to scale, make a purchase, or do a buyout. Your loan will most likely have financial covenants: conditions, such as financial ratios, that you must fulfill to keep the loan in good standing.
The easiest way to ensure sensible covenants is to understand them and to negotiate them well in the first place.
Too many entrepreneurs, founders, and business owners don’t pay enough attention to those covenants… until it’s too late and the bank freezes their accounts or calls the loan.
Before You Take A Business Loan:
You need to not only know what your covenants are, but ensure they make sense for both your business and your business strategy. That means negotiating well, forecasting them, and monitoring them.
Here’s how to do that.
(By the way, not all loans have covenants—they may not if your loans are based on personal guarantees, secured by the assets of your business, or have a borrowing base calculation.)
1. Negotiate: Do the Covenants Make Sense for Your Business?
Pay attention to these four factors to help you negotiate appropriate, doable covenants.
1. Make sure you understand the bank’s goals.
The bank writes covenants to protect itself and to ensure it gets its money back. That makes sense. They typically require liquidity and profitability. In a venture debt situation, they want to make sure your company continues to grow.
Trouble can arise, however, with the bank’s definitions or the terms they seek. When their definitions and ratios do not match your industry, how you run your business, or the stage you are in, you need to negotiate.
Ask the bank: What are you trying to accomplish with this covenant, and what do you mean by these terms? They may look at assets because they want liquidity in case of a default, or enough inventory to be salable, or enough accounts receivable. (It depends entirely on the kind of business you are in.)
Once you understand what the bank wants, you can tell them how you measure those things, my next point. Banks will often adjust covenants to reflect how a business is run.
2. Make sure they understand your business.
One recent client’s bank referred to current assets in their loan covenant. So we sat down with them to ask, “What do you consider a current asset?” They had a specific definition, but this client pointed out that he had a sizeable amount of equipment that was a liquid asset, yet not included. The bank said it was not a current asset—because the bank didn’t truly understand the business.
The owner explained, “At any point, we can return that equipment to the manufacturer and get a full refund. So it’s on site, but it’s completely liquid.” The bank agreed to include it as a current asset for the covenant liquidity calculation.
Similar to clarifying the specifics within a covenant calculation, it’s also very healthy to discuss borrowing base calculations to really understand how you’re reporting and what “counts” for borrowing base!
3. Point out ratios that are too close for comfort.
Let your bank know, “Hey, we’re operating at 2.0 and your ratio is 1.6. Man, I can come up with a number of challenges where, if two or three of these things happen, we’re going to go below 1.6 but still be able to recover.” It doesn’t mean your business is unhealthy. It means shit can hit the fan for a quarter. Ask the bank to drop their ratio to 1.4.
4. You can adjust time periods.
Another way to deal with a ratio that’s too close for comfort is to negotiate a different period. If you might trip up in a single quarter, ask for a rolling 9-month average. Or make it a year, so the law of averages works in your favor. Over the long haul, your ability to course-correct is stronger.
2. Model It Out: What Triggers Your Covenant?
As entrepreneurs, we’re optimists. We always think business is going to go according to plan. But there’s plenty of graphs and LinkedIn charts that show the path of the entrepreneur is not a straight line. It’s a squiggly mess. And you don’t want to trigger your covenant.
1. Add the ratios to your financial model.
Within your forecast model or financial model, calculate the covenant ratios over time (e.g. liquidity ratios) right in the financial model itself. Every time you see you update your results and/or reforecast, you will see the impact has improved visibility as to where you are operating relative to the “line.”
2. Model the covenant in different conditions.
Also look at these ratios in various scenarios. Put the covenant in your model so you can see it and build a chart on it. You want to make sure that, whatever happens, you’re comfortably above that covenant ratio.
One of AVL’s clients had a manufacturer in China that just disappeared—surprise! Now they are out of supply for four months while they switch to another supplier. That’s four unexpected months without revenue, ouch.
If you had a financial covenant and something like that happened, it might trip. It’s hard to forecast the absolute worst, but you can try by asking: what’s a pretty poor year? What’s a poor scenario? What if we didn’t grow at all year-over-year, or what if revenues are dead flat? Know what that does to your loan covenant.
3. Find your trip point.
Another question to ask is: how bad would it have to get to trip any (or all) of our covenants? Build a forecast model that breaks the covenant and remember where that trip point is.
It helps, as you run the business, to know where your boundaries are and when you may need to take some more drastic action to avoid loan default.
3. Talk to More than One Bank
As I’ve said in other posts, every entrepreneur needs to maintain a long-term, good relationship with a bank. When you’re getting started, it’s important to talk to more than one bank.
1. Shop around: banks vary.
The market can be fairly inefficient in terms of pricing, loan terms, and covenants. Loan officers vary in experience, too.
Here in Denver, I work with a banker who’s been in the outdoor industry a long time, so I introduced him to an e-commerce company focused on kids’ bicycles. Immediately he understood the bicycle market. He already knows where they’re manufactured, how they come into ports, the seasonality, and inventory management. His experience will probably result in more insightful covenants (or borrowing base) because of his expertise. Shop around.
2. Never underestimate the bank’s own strategy to run its business.
Every bank has their own strategy and loan portfolio needs. I’ve seen a bank heavy in real estate decide to do more commercial loans. When they got into commercial, however, they hit some bumps and decided to reverse strategy and focus back on real estate. When our client, who was struggling on their revenue goals, went to renew their credit lines, the bank said it was no longer interested in taking the loans. We searched for a new banker, but in the meantime, the loans went into the bank’s “asset recovery group” because the company didn’t pay off the loan on a timely basis.
As another example, another AVL client did trip a covenant on their loan. And unfortunately, it happened to be the fourth loan that had defaulted that quarter for their bank. Because of that, the bank wanted to (needed to) clean up their loan portfolio and get rid of the loan ASAP. So they froze all the client’s bank accounts. That company couldn’t write a check or effectively operate the business.
The bank only wanted to get their cash back, but their actions severely impacted this client. Please know this does not happen often, and but the reputation and stability and strategy of the bank is something to really understand. The key is developing a solid relationship with a bank that has been serving other companies in your industry a long time, a steady Eddie.
4. What If You Already Signed a Loan?
That’s a little tougher. One, strengthen your relationship with the bank when you can. Two, if something materially changes in your business, hopefully for the better, it may be an opportunity to approach the bank and say, “Hey, I know we’re in year two of a five-year loan, but I want to talk about re-negotiating this, re-kicking it.”
Obviously there’s a cost of redoing debt, but if you have a strong reason (more than wanting to tweak a covenant), they shouldn’t be opposed to it. And if they don’t want to, another bank might.
When trouble appears on the horizon, ask for a waiver. If you can see that two quarters out, you’re going to get really close to your covenant ratio, I’d sure as heck get in front of my banker today. Start sharing the model with them.
Banks can do waivers, especially if you have a really good plan as to how you’re going to back on track. They can waive a covenant for a specific period, or drop the ratio from, say, 1.6 to 1.4 for a time, or whatnot. If you get in front of them when you first see a challenge, you might see a lot of flexibility in your banker. And that would strengthen your relationship, always a good thing. With that said, don’t “cry wolf”. Use this sparingly.