advisory & consulting

six kinds of loan covenants

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by ed mendlowitz
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negotiating the best loan terms, rates and conditions such as an annual cleanup and compensating balance amounts is done with the sharpest skills … not so much skill mining the loan covenants or restrictions.

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loan covenants determine conditions the borrower must adhere to and when the bank has the right to call the loan, renegotiate the terms and rates, impose additional restrictions or controls, send in an auditor or assess extra charges or fees.

checklist: six critical covenants

here is a rundown of the types of covenants.

  1. reporting covenants cover the type of financial statements and other schedules that must be provided to the bank, and their frequency and possibly the right to veto the choice of the independent auditor.
  2. financial condition covenants could state minimum net worth, working capital levels and maximum equipment spending.
  3. distribution covenants restrict or limit salaries, other compensation payments and dividends to, or stock buybacks from, shareholder/employees and owners.
  4. ratio covenants require certain financial levels and ratios to be maintained and include working capital, debt service and debt to equity ratios.
  5. action covenants could require certain steps that must be taken such as using a lock box for customer payments, adding a board member or establishing a board of advisors.
  6. restriction covenants can affect additional borrowings, unfinanced equipment purchases or mergers and acquisitions.

care should be taken to set covenants in reasonable amounts that are likely to be achieved, or in the case of equipment spending, amounts that are not too restrictive of the business’ growth plans. net worth covenants are usually set at current amounts with the only violations being business losses or distributions to owners that obviously will reduce net worth.

if you are going to have expected write-downs of assets such as inventory or equipment or a large customer bad debt, tell your bank representative as soon you know or while you are considering it so they can assist in re-evaluating the effect on the covenant.

if you are negotiating new covenants, make sure you do not agree to something that a simple projection would indicate you would not meet for an extra year. also, consider consequences on the covenants when the business is expected to be reacquiring stock from a retiring shareholder or their estate.

if a company is a passthrough entity such as an llc or s corporation, exemptions should be provided for distributions to cover personal income taxes on the business’ profits that are taxed to the owners but retained in the business.

when a covenant is not met, and the bank wishes to maintain the relationship, they would grant a limited waiver of the covenant – usually for not more than one year.

your best friend when you don’t think you will meet the covenants could be your bank representative, provided they are kept informed about adverse situations. bankers do not like surprises.