The Art of the Covenant

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Avoid methods of communication that might suggest you don't take the problem seriously. That means no quick notes or phone calls. "Ask your banker to come to your office to meet with you and your attorney and accountant," advises Fineberg. "Be prepared to give a full explanation of what's gone wrong and what you're prepared to do to correct it." It's a good idea to follow up on such a conversation in writing.

MYTH: You'll never escape from all these covenants.

REALITY: Once you have several banks competing to win you as a customer, it's much easier to negotiate less restrictive covenants. That's playing the best banking game of all: "Let's Make a Deal."

Now What? Take This to the Bank

It's not easy navigating your way through the loan-covenant jungle, especially at a time when bank mergers have added inches to many boilerplate documents. Here are five steps that should help:

1. Find out whether your prospective bank plans to retain your loan or sell it. In the latter case, there's probably less room for maneuvering over covenant issues.
2. Inquire about the bank's expertise in--and funding experience with--your industry. Covenants from industry specialists are often more realistic.
3. Ask to see a sample list of covenants before the date of the closing, so that you can avoid a situation in which desperation for funds--or a lack of careful analysis--persuade you to simply sign anything. Make certain that you can live with the bank's terms about the consequences of going out of compliance.
4. Do a computer run of your company's past performance during the most recent one-, two-, and three-year periods to see if you could have complied with all loan covenants, especially key ratios, if your loan had been in place before now.
5. If those results indicate future problems, schedule a visit with your banker and suggest more realistic covenants.

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   Jargon: Lingua Banker

   There are more potential covenants in a loan agreement than ingredients in a gourmet dinner. But here are some types of restrictions you may encounter:

   • Full disclosure. "Banks were burned badly during the 1980s, when they often relied on information that turned out to be inaccurate or misleading," notes banking consultant Douglas Fineberg. Now most demand audited financial statements on an annual, quarterly, or even monthly basis. (That frequency is a hidden loan cost, since the more often you need audited statements, the higher your compliance costs.) Other covenants may spell out how soon you'll need to notify the bank of significant changes in circumstances, such as the loss of a major customer.
   • Salary caps. Bankers want to prevent the top management from removing so much cash from the company that loans don't get repaid. Salary caps might be tied to a percentage of sales or profits, or simply appear as a dollar limit.
   • Key ratios. Bankers track various financial ratios to make certain your company can handle its loan payments. "You'll often see what's loosely called a liquidity ratio," says lawyer Douglas Reynolds. "This might calculate pretax income before debt payment and then compare it with whatever the company will need to service its debt--meaning the interest plus principal payments--and also be able to continue to operate." Other key ratios can vary widely; not all banks rely on the same formulas or definitions. You can probably expect some version of a quick ratio (cash plus cash equivalents and accounts receivable, divided by current liabilities) and a current ratio (current assets, including inventory, divided by current liabilities). The rules differ, but expect to see covenants approximating 1 to 1 for a quick ratio and 2 to 1 for a current ratio.
   • Net worth. You may encounter a whole group of covenants about your company's (and sometimes your personal) net worth. The loan agreement often specifies a minimum value below which your company's net worth should not drop. You may also be tied to a debt-to-net-worth ratio.
   • Personal guarantee. This is essential to many small-business loans. As soon as you prove your company's creditworthiness, negotiate to remove this covenant--fast.

   Jill Andresky Fraser is Inc. 's finance editor.

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   Resources

   For an exhaustive discussion of the dos and don'ts of loan covenants, George Dawson's newly published book, Borrowing to Build Your Business: Getting Your Banker to Say Yes (Dearborn Upstart Publishing, 800-448-3181, $15.95), can scarcely be beaten. It's readable, it's sophisticated, and it truly is full of important insights about loan committees, bankers' "code" phrases, and the way to win the best financing arrangement you can. As is often the case with top-notch business books, Dawson's end-of-the-book glossary is worth memorizing...certainly before your next encounter with a prospective banker.

   ALLEN SYSTEMS GROUP, Frederick Roberts, 750 11th St. South, Naples, FL 33940; 941-263-6111 99

   DOUGLAS FINEBERG, P.O. Box 1628, North Hampton, NH 03862; 603-964-7325 99

   PEABODY & ARNOLD, Douglas Reynolds, 50 Rowes Wharf, Boston, MA 02110; 617-951-2100 99

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