Understanding Financial Provider Lending Covenants

By Mark Borkowski

In his 35 years of commercial and merchant banking experience, Michael Kavanagh of Ariem observed that few entrepreneurs in the small to medium category fully understand or appreciate the significance of lender/investor covenants. The entrepreneurs were focused on the financing amounts, security (primarily personal guarantees) or interest rates when an offer of finance or a credit renewal was presented. However, they generally pay little attention to the covenants or other requirements stipulated by the lender.

This lack of focus or ignorance can be downright dangerous as they could seriously impair the financial stability of the business if circumstances push the covenants offside.

Almost all businesses require third party financing from a Chartered Bank, term or other lenders including Equity investors. The financing is used to fund day to day operations as well as to grow. The funding is needed to pay salaries, purchase inventory and to produce product as well as to pay for all the other expenses used to run the business.

This third-party funding is provided with conditions concerning use and the company maintaining or exceeding conditions of financial performance or covenants. A covenant is a type of contract in which the covenantor [borrower] makes a promise to a covenantee [lender] to do (affirmative covenant) or not to do some action (negative covenant)
In the lenders/investors offers of finance and legal documents, these covenants are outlined with explanations on how and when they will be reviewed. These are very important and it is imperative that borrower understands the definitions, calculations and timing. These covenants are tested at intervals based on receipt by the lender/investor of internal interim financial statements or at year end based on third party auditor [accountant] prepared financial statements.

Below is a very brief listing of some of the type of covenants that banks and investors include in their financing offers and legal documents:

– Minimum Fixed Charge Coverage Ratio
– Senior Debt / EBITDA Leverage Ratio
– Minimum Equity Covenant
– Working Capital Covenant
– Minimum Equity levels
– Debt to Equity Ratio Covenant

In addition, there are many negative covenants including payment of bonuses, redemption of shareholder loans, capital expenditure levels and cross default with other lenders. This listing is by no means comprehensive. The type of financing/investment will dictate the types of covenants required.

As noted above, Bankers/Investors treat these covenants very seriously and, you as a borrower should have the same regard. Kavanagh has seen instances where the borrowers and auditors have tried to be creative and adjust numbers to bring one covenant on side but caused another covenant to go offside. In other instances, the covenants have been ignored or downplayed. Not good!

Kavanagh also noted that there have been many instances that there were no notes to explain the results when the quarterly financials or year end statements are provided. As an example, Kavanagh received an audited year end statement from a large transportation company with not even a covering letter. This statement went to all lenders simultaneously. The results were very poor and both the auditor and the CFO missed the fact that there were serious breaches in the lending covenants. The lenders issued notices of default and the company encountered severe distress as loans were demanded or severely reduced.

While bank financing is demand meaning, the bank can act for any reason, a covenant that is offside will undoubtedly increase the chances of the bank taking action. These actions could include a reduction of authorized availability amounts, demands for increased security or, if serious enough, a demand for payment of the total authorized amounts. In all these circumstances, these potential actions are not good for you and the company.

Both Kavanagh and Khosla noted that communication is key. If there are covenants offside, a detailed explanation of why there are defaults and the plan to bring them back on side should be presented. If the lender sees there is acknowledgement and a credible plan to bring back in covenant within a reasonable time period, they will undoubtedly work with the company.

Khosla advised that the company’s CFO should be conversant with these but additional advice can also be obtained from your Outside accountant. If you do not have a CFO or you believe that you need outside advice, Kavanagh or Khosla at Ariem can also provide independent detailed guidance and understanding as well as assisting in providing reports to the stakeholders.

Keeping the firm’s good financial liquidity is extremely important to grow and therefore fully understanding the lender’s covenants needs to be top of mind. Being proactive is key and if you don’t fully understand seek experienced help to avoid potential troubles down the road.

Ariem is an entrepreneurial company based in Mississauga, Ontario whose goal is to help small and medium sized businesses solve their operational and financial issues. Visit our web site: www.ariem.ca

Mark Borkowski is president of Mercantile Mergers & Acquisitions Corporation. Mercantile sells mid-market companies to strategic buyers, private equity firms and high net worth individuals. www.mercantilemergersacquisitions.com