A commerical lending banker discusses loan covenants and what happens if such covenants are broken.
Restrictive loan covenants can be the bane of an entrepreneur's existence.
"Generally speaking, growing companies face a better chance of obtaining favorable loan covenants if they negotiate with smaller, regional banks that actively want their business," says Devin Blum, a vice-president of commercial lending at the Adams National Bank, in Washington, D.C. He contrasts the relative flexibility of small lenders with the rigidity of "the larger money-center banks, which tend to impose cookie-cutter covenant formulas on loans to smaller companies."
Still, some loan covenants are inevitable (especially for first-time borrowers), since every bank must protect its loan. Here are some commonly invoked covenants:
· Debt-service ratios that require a borrower to maintain monthly positive cash flow of at least 1.5 times the amount necessary to pay annual interest and principal charges.
· Compensation ratios that limit what CEOs pay themselves to a maximum percentage of total sales.
· Liquidity ratios that ensure an adequate supply of ready cash. "But," Blum notes, "these covenants vary by a company's industry norms and market position, and probably also by stage of development."
Should a company violate any of its covenants, its managers should expect their bankers to monitor monthly results closely and perhaps even require the loan's immediate repayment. But if a fast-growing company can document that it has adhered to its bank's covenants for even a year or two, it may be able to negotiate for looser guidelines.
"Many business owners fail to realize that everything, within reason, is negotiable. You just need to be able to point to a record of profitability, an internal capability of producing thorough financial reports, a strong market position, and a strategic business plan," Blum says.