Demystifying Debt: Understanding the Covenants That Govern Borrowing
Businesses turn to a variety of capital options to assist them in completing an acquisition, implementing internal succession plans, providing working capital for growth, or purchasing a hard asset (building, computers, etc.). The capital options consist of traditional banks, private lenders, friends and family debt, and/or seller financing.
When a business takes out debt, they will sign a loan document package which takes on several forms. The main document will be the note or loan agreement. This contains critical information about the loan you are taking out including the amount, repayment period, interest rate, and last, but certainly not least covenants.
There are typically two kinds of covenants in loan documents: affirmative covenants and negative covenants. Affirmative covenants detail the actions a Borrower is allowed must adhere to or achieve while the loan is in place. Potential affirmative covenants include financial covenants, reporting requirements, the amount of insurance needed to be in place, compliance with laws, etc. Negative covenants describe actions not allowed while the loan is outstanding. This may include selling assets, taking on additional debt, the amount of dividends a company can take, a restriction on executive salaries, etc.
One of the most critical types of covenants would be Financial Covenants. Typically financial covenants are certain ratios or metrics a business must obtain to stay in good standing with the lender. There are many potential financial covenants. Some focus on the balance sheet, income statement, or some combination thereof. The lender outlines in the Loan Documents when the Financial Covenants will be tested and whether the borrower needs to submit a compliance certificate detailing the calculation of those covenants.
Different types of lenders tend to prefer different financial covenants in their document package. A few of the most common financial covenants for financial services companiesinclude the following:
Debt Service Coverage (DSC): this is the ratio of EBITDA (Earnings before Interest Depreciation and Amortization) of a period divided by the debt service of the same period. This can be done on just the Senior Debt or all the debt the business incurs (Senior, Junior, Mezz, EIDL, Seller Notes, etc.). This ratio tests the business’ ability to generate enough cash(EBITDA) to pay the scheduled debt service. Lenders typically like this ratio to be greater than 1.25x if not a much higher threshold.
Funded Debt to EBITDA: this is the amount of Senior or Total Debt a business has divided by the cash earnings of the company. This ratio tests the total cash flow leverage of the business. A business that is highly levered may be more likely to not be able to repay the debt. If a business has a Funded Debt to EBITDA of 7.0x and the market value of the business is 6.5x, the lender will have a value deficit if the Borrower sold. Lenders typically try to keep this under 3.0x or 4.0x for financial service companies with some exceptions for stronger or larger businesses.
Net Working Capital: this is the business’s short-term assets less the short-term liabilities. This determines whether the company can generate enough cash to repay liabilities due in the next 12 months.
Fixed Charge Coverage Ratio (FCCR): this calculation has some variable components based upon each specific lenders’definition. This ratio tests a company’s ability to generate enough cash flow to cover Fixed Charges such as rent, utilities, and debt repayment. It is similar to the Debt Service Coverage. An example of the Fixed Charge Coverage definition would be EBIT + Fixed Charges Before Tax Divided by Total Fixed Charges.
Other Financial Covenants may include:
Debt to Net Worth: The amount of Debt divided by the Book Net Worth of the business. This ratio tests the balance sheet leverage of the company. This ratio can be calculated on a total Net Worth or Tangible Net Worth basis. A Tangible Net Worth calculation would remove any intangible assets (goodwill, client lists, intellectual property, etc.)
Liquidity: the amount of cash or short-term liquid assets (marketable stocks, cash value of life insurance, CD’s, etc.). Lenders may test this at the company level or on the Personal Guarantor (the individual guaranteeing the debt)
When a Borrower violates one of the affirmative or negative covenants, they technically create an act of default. Does this mean the Borrower should panic and the lender will immediately take the business? Not necessarily. It is important to establish a sound working relationship with the lender prior to signing the loan documents and understand the lender’s measures and methodology around handling a default. A lender’s primary concern involves the borrower’s ability to repay the debt. In most instances, they will want to work through what caused the violation, what measures can be taken to resolve the violation, and what both the Borrower and Lender can do to put the company back in good standing. A borrower’ s transparency to the Lender on a covenant violation typically goes a long way in establishing a mutual beneficial resolution to a default.
There are 4 typical responses to an act of default:
Waiver – the lender waives the default and Borrower returns to good standing. This could be due to a timing error on the covenants, a one-time mistake.
Forbearance – the lender wishes to keep the borrower in default in exchange for a short-term restructuring of the debt to allow the borrower to return to good standing. This could involve interest only payments or a restructuring of the repayment amounts.
Demand – the lender could demand payment and the Borrower would need to find alternative financing.
Foreclosure – the lender files proper paperwork and forecloses on the stock and assets of the business. This would give the lender the right to sell the business for an amount to settle the outstanding balance. Any deficit would fall upon the personal or corporate guarantors, or any other collateral provided in the Loan Documents. Most lenders view this as a last resort as it is timely, costly, and typically does not yield the maximum repayment amount on the business.
When taking on debt, it is critical for a Loan Applicant to partner with an experienced team that understands loan documents, structuring, and lender reputation. This could include a CPA, lawyer, or M&A Advisor.