Commercial bank lending is the most common source of business financing and is also usually the least expensive form of capital. Across industries, the recent financial crisis has decreased access to bank financing making this form of historically available financing more difficult for companies. Lending standards have also become stricter, and the declining value of real estate has reduced available collateral. Access isn’t the only thing that’s changed. Tighter oversight of banks has brought a renewed emphasis on bank loan covenants, which can put constraints on a company’s growth, increase the overall cost of debt, and raise business risks.
Bank covenants set minimum standards for a borrower’s future conduct and performance and typically accelerate the maturity of the loan in the event of a violation. Covenants establish benchmark metrics that are intended to ensure that your company stays financially healthy and, that the bank’s investment is protected. They are generally classified in two broad categories, restrictive or financial, and within these categories can either be affirmative or negative. Affirmative covenants require your company to meet certain standards defined by the bank, such as maintaining a minimum level of liquidity, revenues or profitability. Negative covenants are intended to restrain you from taking specific actions, such as adding more debt, making investments or replacing top management, without the bank’s approval.
Some covenants occur more frequently in loan documents than others, and some are more constricting and potentially more challenging for a company. The main types of covenants typically encountered in commercial debt financing include:
- Financial covenants are restrictions based on specific balance sheet, income statement or cash flow items. They may be most commonly used category of covenants. These covenants are directly measurable and verifiable based on accepted metrics from the company’s financial statements. Common financial covenants require a company to maintain a minimum level of liquidity (indicated by a minimum “current ratio”) or equity (measured as a percent of assets). Other covenants may cap leverage or a company’s debt by asserting a maximum debt to equity ratio, or minimum debt to cash flow coverage ratio.
- Operating activity covenants dictate how you operate your business. The more restrictive covenants in this category will prevent you from using business proceeds (your capital and profits) for certain purposes without bank approval.
- Reporting and disclosure covenants set the minimum standard of periodic financial reporting with your bank. More restrictive covenants in this category may permit the bank to demand to see your records at any time without advance notice.
- Preservation of collateral/seniority covenants require you to maintain the collateral you’ve provided for a loan and ensure the bank’s senior lien position remains intact.
- Investment expenditure covenants can prevent you from making certain capital expenditures, strategic acquisitions and other cash investments that could be beneficial or competitively necessary for your company’s growth.
- Asset sale covenants may prevent your company from selling off assets during the course of business, restricting transfers and voluntary liquidation as well. You may be forced to hold onto underperforming assets to satisfy these covenants and lower the returns on your capital.
- Cash payout covenants restrict dividends, prepayment of subordinated debt – even prepayment of the bank loan itself. These kinds of provisions could inhibit the ability to buy out a partner or shareholder.
- Financing covenants impose limits on debt, debt-like contracts such as leases, or on changes in capital structure. They restrict loans to subsidiaries, sale-leasebacks, and other financing arrangements. Routine equipment leases and inter-company financing transactions may be subject to bank approval under these types of covenants.
- Management, control and ownership covenants restrict the governance structure of your company, keeping you from merging with other firms, consolidating your business, transferring ownership or changing your management or board without explicit bank approval.
Covenants can be negotiated with the bank as part of structuring a loan deal. The covenants that are agreed to can have broad interpretations and implications for your company. Tripping a covenant, however small, can mean losing your funding entirely. That’s why it’s vitally important to know what each covenant in your loan agreement means, to negotiate the most favorable covenant terms available to your company, to notify your bank as soon as possible if you are headed for a breach, and make sure to have an alternate source of financing available.
Whether or not you are in good standing with your bank, you should always have a relationship with a second lender for a few key reasons. Conditions at banks change frequently, due to acquisitions, regulatory issues or internal needs, so having a second source of capital lined up gives you somewhere to go if you lose your funding. A second lender can also provide additional liquidity when you have reached your credit limit with your bank. You can augment your liquidity with more flexible financing options that are less likely to complicate your relationship with a primary lender.
Bank financing is for most companies the primary source of crucial short and long-term financing. Successful negotiation of loan covenants will increase the probability of maintaining good banking relationships critical to the company’s capital needs. Therefore it is vitally important for companies to have a solid perspective as to current and forecasted operating needs, based on varying scenarios of business and market risks, as well as growth goals and the related investments required. Strengthening a company’s banking relationships and improving/increasing access to bank financing for current and future needs can be a key factor to success and is considered a primary function of a Harvest CFO.