If you have ever turned to your bank for a loan or line of credit, you know about bank covenants and have agreed to them. A covenant is a clause in the loan agreement that requires the borrower to do, or refrain from doing, certain things.
The best time for a business to deal with bank covenants is when a loan is coming up for renewal or you are negotiating a new loan. Your bank will typically use the financial projections you provide to set the financial covenants. Consider putting something in the loan document that states how you might rectify a missed covenant, such as putting equity into the company, subordinating existing or new debt to shareholders, or adding collateral to the loan (i.e. pledging some stock portfolio or cash).
It is very important to have the utmost confidence that you can meet the financial goals in the projections you provide to your bank. We typically advise our clients to create three sets of annual projections:
- The bank version: The most conservative projection and the one your entire management team believes is attainable.
- The most realistic: The scenario that is the most probable and that will serve as the benchmark for management’s performance.
- The stretch budget: The potential result if all the stars were to align. This might be used for your sales team.
Sometimes, despite everyone’s best intentions, companies fail to meet their bank covenants. When this happens it is smart to meet the situation head-on. If you are in the middle of the year and believe there is a chance you may not meet a covenant, review current projections to determine what steps can be taken to remedy the situation. If it is a leverage covenant (debt and/or equity), consider collecting accounts receivable more quickly, or requesting customer deposits to pay down liabilities. Or you might decide to defer some fixed asset additions until the following year.
If it is a debt service coverage ratio and you do not expect to meet the projected income, this can be tougher to resolve by year-end. You can consider deferring owner distributions and/or making contributions so the covenant is met (be sure to read the definition in the loan agreement).
If you are really in doubt, we recommend discussing the situation with your banker before you have violated the covenant. The earlier this discussion takes place, the better. Explain why you might not meet the covenant and ask if it can be amended for just the current year. Remember, your loan officer does not want to have to explain the violation to his or her superiors. If it is the debt service coverage ratio (the most common issue-causing ratio) and you have easily met the covenant in prior years, but something unusual happened in the current year, you will have a much better chance of getting the modification.
If you have already violated a covenant and you have not discussed it with your banker, you should do the following:
- Provide projections to the bank that show you will meet the covenant going forward.
- Consider putting more equity into the company or adding more collateral to the loan.
- Request a bank waiver. Keep in mind this could generate an additional fee and some loan terms may be changed (e.g. higher interest rate).
Remember, your bank is a key business partner. You should keep them aware of what is happening in your business so there are no surprises (good or bad) when financial results are shared. If you have treated them as a partner, have been a customer for a long time, and have maintained a good relationship, you will be in a much better position to deal with a covenant violation. If you are a new customer and selected the loan based solely on price, the bank’s profit margins are slim and your banker will have much less leverage with his or her superiors to request and obtain a waiver. You may also experience higher waiver fees and an increase to your interest rate.
David E. Shaffer can be reached at Email or 215.441.4600.
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