The Art of the Covenant

Inc.'s finance editor tells you everything you need to know about loan covenants.

By Jill Andresky Fraser | 
 

Business 101

Everything you need to know about loan covenants

Two years ago Allen Systems Group Inc., a computer-software manufacturer based in Naples, Fla., was almost ready to sign a new credit agreement. But its chief financial officer, Frederick Roberts, was concerned about an essential yet often-overlooked component of the deal: the loan covenants.

"Our banker wanted to include some very strict covenants regarding the company's key financial ratios," Roberts recalls. Those covenants "would have wound up hampering our ability to grow, because they would have prevented us from acquiring some important new software products. Each acquisition would have put us temporarily out of compliance."

Roberts was determined to negotiate the $23-million company's way out of those requirements--or seek financing elsewhere. "Too many entrepreneurs get ecstatic just over the act of qualifying for bank funding--but then fail to pay attention to the fine print of the loan agreement," he says. "If you're not watching and you fall out of compliance with a covenant, you run a very powerful risk of getting your loan called in, whether you're up-to-date on your payments or not."

Loan-covenant problems are fairly common for fast-growing companies, whose financial statements seldom conform to a banker's ideal vision of fiscal health. Roberts, armed with short- and long-term financial projections, eventually won "more appropriate" terms, as he puts it. But many other companies either don't try to change their bank covenants or don't worry about future problems those covenants might pose.

Would your own approach have been simply to sign up, close the loan, and hope for the best? Then it's time for Inc.'s quick primer on loan covenants. Don't visit your banker without it.

MYTH: With bank financing, all that matters is the interest rate.

REALITY: Many banking experts believe that interest charges are among the least important features of a loan. "After all, interest is a deductible business expense, so the government is really helping you handle it," notes George M. Dawson, a banking consultant based in San Antonio, Tex.

Loan covenants, on the other hand, are extremely important to your banker. A violation of a loan covenant is "the bank's early-warning system that something might be going on in your company that's a sign of trouble," Dawson explains. "It's like a blip suddenly appearing on the radar that tells the bank to pull its loan before something really bad happens."

Given how heavily the U.S. banking industry is regulated, your banker's attitude makes sense. Banks aren't supposed to engage in high-risk investments that could endanger their customers' savings. Meanwhile, banks can't monitor their investments in companies like yours on a daily, or even frequent, basis. Loan covenants have evolved as banks' next-best safeguard, through monthly, quarterly, or annual regulation of key financial ratios and other essentials.

MYTH: Until your company is supersuccessful, you won't be able to qualify for better covenants, so why try to negotiate?

REALITY: Once a bank decides to give your company a loan, it's in the bank's interest to make the entire loan agreement as accurate as possible. But if you don't warn your banker that a covenant just won't work, how will he or she know?

"This is the stage to stop selling to your banker and, instead, start setting realistic expectations," explains Douglas Reynolds, a partner at the Boston law firm Peabody & Arnold. He and other experts agree that business owners won't jeopardize a loan simply by trying to negotiate covenant issues. If a requirement is inappropriate for your industry or your business, tell your banker why--before you sign a loan agreement. Be prepared with documentation (especially past financial records), as well as with suggestions about alternative standards your company could meet.

MYTH: If you've made all your loan payments on time, your banker won't really mind a slipup or two on a covenant.

REALITY: Don't kid yourself. If you anticipate falling out of compliance during any period that your banker monitors, you could wind up in hot water.

At the first sign of trouble, Douglas Fineberg, a banking consultant based in North Hampton, N.H., warns company owners to "very realistically assess the situation. If the problem is one of an extremely short term nature, and you're convinced you can correct it before you're due to report results to your bank, then you probably don't have to worry. But if you can't cure it fast, then you have to look for ways to minimize the situation."

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