February 11, 2020
Coming from a lender, this may be self-serving: “Loan covenants get a bad rap.” The truth is covenants, and the covenant setting process, are actually a good thing for both lender and borrower alike. Whatever the relationship, customer, employee, or marriage, setting expectations is a critical element to success.
Loan covenants establish a minimum level of financial expectations of the borrower and are established after in depth analysis and understanding of the borrower’s business. A well-informed lender, who truly understands your business, is a valuable partner. When reality falls short of expectations, loan covenants serve as a basis for further analysis and communication by both lender and borrower. Covenants should be established as an early warning sign for all involved to assess performance when financial results fail to meet the common expectations of the borrower and the lender. In doing so, covenants can identify potential risks be they extended sales cycle, customer churn, development costs, or others, before they happen – often prompting a conversation and actions by the borrower to course correct in real-time.
The worst possible situation is for the borrower to be running 110 miles per hour toward the edge of cliff and only notify the lender when the company is perilously close to the edge. In that situation, there is a high probability that the lender demonstrates Newton’s third law of motion: “For every action there is an equal and opposite reaction.” Effectively, covenants help reduce risk to all parties to a loan.
If you’re an entrepreneur, there’s a good chance at some point you’ll explore debt financing options for your business, and you must understand how covenants work and how they can benefit you. Covenants generally fall into two broad categories; reporting and financial. Reporting covenants generally define what financial information and certain other important documents must be delivered to the Lender and when. Financial covenants can be divided into two groups; incurrence covenants and maintenance covenants. Incurrence covenants generally allow the borrower to do certain things, provided that in doing so, no financial burdens adverse to the lender are incurred. Maintenance covenants are designed to monitor and maintain expected financial condition. For example, the borrower must maintain positive working capital, or a minimum interest coverage ratio.
The process of developing and agreeing to covenants is often among the first meaningful interaction a borrower and lender have. There’s a lot that can be learned and discerned about the other party and their business during this process.
Developing covenants can act as a primer for the relationship. Simply having this interaction helps the borrower and lender achieve a better understanding of how the other works. These interactions can tell you whether you’re working with a person who is flexible or if they are rigid and unyielding. You get to see how they react to your needs. Are they willing to listen and understand your needs, or does what you’re saying fall on deaf ears? Do they demand a lot but are unwilling to give up much in return? Do they work fast and loose in their dealings with you or are they diligent and detail oriented?
A lender may be providing significant amounts of capital to help grow a borrower’s business. In the case of a senior secured loan, the lender has a first claim on all of the assets and cash flow of the business. In other words, the lender gets paid before the equity owners receive any value. Given that equation, it is in a borrower’s best interest to ensure that the lender has a deep understanding of their business and how the business performs in a variety of circumstances. This process also requires the borrower to give advanced thought and planning to what levers it has in the business when financial performance falls below expectation, and consider the impact on all constituents.
Entrepreneurs are by definition optimists. If not, they would have never started a business and certainly do not see failure as an option. It is that very spirit that has attracted the lender to your business. With that in mind; however, financial performance is not always up and to the right on the results graph. Borrowers may have their core financial plan against which they measure themselves, but it is advisable to develop a “covenant case” or “bank case” to use in covenant negotiations with lenders. This will clearly flush out the minimum performance levels with which the lender is comfortable and give the borrower reasonable cushion to maintain compliance.
The exchanges around crafting covenants often color all future interactions. While you’re defining the parameters of your engagement, don’t forget to pay attention to what are sometimes the first real clues into who you’re working with. Remember that not all lenders are nimble, and it may take time to get through credit or investment committees when change is required. Non-banks likely have in edge in this area, but everyone has a variety of constituents which they serve and that may affect the covenant setting process and will certainly impact any subsequent modifications or adjustments.
Let’s discuss how each party is protected by covenants. The lender uses covenants to identify changes in risk associated with a loan. No financial covenants will ever repay a loan, but they will identify changes in performance and risk in the borrower’s business. Lenders want the transaction to be a success – the borrower uses the capital effectively and repays the lender in full. To better manage risk, lenders identify potential financial risks before they happen. These could be risks associated with increased leverage, acquisitions, extended sales cycles, customer churn, or declining working capital to name a few. To the entrepreneur, this can seem controlling, but it is actually a conservative and thoughtful approach meant to keep the business operating between pre-defined guardrails and to get in front of potential adverse conditions that could ultimately jeopardize the success of the company and the safety of the loan (i.e., default).
For the borrower, they have full transparency into what is required to ensure a successful outcome. If the borrower colors outside of those lines and trips a covenant, it doesn’t mean the loan automatically defaults, or the interest rate increases. It does force a meaningful dialogue between the borrower and the lender to find the best resolution.
Additionally, covenants reduce the cost of borrowing. Because the lender is able to be assured some financial guardrails in which borrowed funds will be used, risks are reduced, allowing lenders to have more confidence in the outcome. Quality lenders do not use covenants as a tool to reset originally agreed upon terms and conditions when borrowers hit a small bump in the road. If the borrower’s business has changed such that the risk profile of the loan is substantially increased, there may will be some change in economics. Until then the borrower can enjoy lower borrowing costs.
Let’s look at an example of a covenant commonly placed on a loan. Company A borrows $5 million from Lender A at an 8% interest rate. Given Company A’s risk profile, Lender A has a covenant in place that restricts Company A from borrowing from another lender. Otherwise, Company A may try to borrow an additional $10 million from another lender at a 15% interest rate, which would significantly change Company A’s risk profile after the fact.
Otherwise, you wouldn’t receive the loan. Lending to borrowers who default on their loans would be very expensive, risky, and not sustainable. To decide if you’re a good choice for a loan, lenders analyze your business and create a risk profile. All loan conditions are set based on your risk profile and ability to repay. Covenants are put in place to maintain that picture and keep it from deviating too far outside of the frame. This gives the business a little flexibility but not so much that it creates an adversely risky scenario for the lender.
The interest rate and terms you’ll receive are all based on the above two factors — risk profile and ability to repay. The fact that the lender has approved the loan means they believe you’ll be able to repay in full. Covenants are included to define expectations for both sides.
Loan covenants are there for the benefit of all. A thorough analysis together with your lender will establish parameters (guardrails) documented as covenants in the loan agreement to ensure your business prospers during the life of the loan. Trying to take on more than what is outlined by the covenants can lead to a financially negative outcome.
As you can see, covenants can be a primer for the borrower/lender relationship and improve the level of understanding between the two parties over the long term. They are also beneficial in helping both parties create an actionable outline for how particular situations should be handled. Covenants set expectations and help avoid disagreements since everything is defined, documented and agreed to when the loan is made. Taking the time to develop appropriate covenants with the other party is certainly time well spent.