Although high interest rates may no longer be headline news, loan obligations remain a driving source of stress for many business owners. Loan financing is fundamental (and often unavoidable) for many businesses. Loans can fund expansion and new projects, smooth out irregular revenue realization and enable investors to leverage their capital contributions into greater returns.
Not surprisingly, lenders attach many strings to borrowers as a condition to funding a loan. Although interest rates and payment obligations will always be the core loan terms, lenders require much more than timely payments from their borrowers. This article will summarize common financial and operational covenants, banking and services covenants and monitoring covenants, and address why borrowers should give these covenants careful consideration.
Financial and operational covenants
A lender’s willingness to underwrite a loan and to allow the loan to remain outstanding depends on the lender’s confidence in the borrower’s financial health. Accordingly, lenders require their borrowers to satisfy financial and operational benchmarks that demonstrate the borrower’s ability to repay the loan.
Among other financial covenants, lenders typically require their borrowers to achieve and maintain certain ratios that measure the borrower’s financial performance relative to its loan obligations. Two common minimum ratios are the following:
- A debt service coverage ratio (DSCR), which measures a borrower’s earnings before the deduction of interest, taxes, depreciation and amortization (EBITDA) or net income relative to its scheduled loan payments
- A debt yield or leverage ratio, which measures the borrower’s EBITDA or net income relative to the loan indebtedness owed.
Particularly when a business is incurring a loan to fund expansion or new projects, the borrower will need time to ramp up before a high DSCR or debt yield can be achieved and maintained.
Lenders often impose additional performance covenants that are tailored to the borrower’s business and if missed, indicate the borrower’s financial performance will eventually fail to satisfy lender expectations. In multi-family housing for example, borrowers are required to maintain minimum occupancy levels. In other industries, borrowers may be required to exceed minimum production or recurring revenue levels.
Banking and service requirements
Lending banks are increasingly requiring their borrowers to transition all of their banking and money management services to the lender, providing the lender with additional income streams from the borrower and bolstering the bank’s deposits.
Changing banks can be a substantial hassle and borrowers often become frustrated when they realize they are required to transition away from services on which their business has historically relied.
Monitoring covenants
To monitor a borrower’s financial health and covenant compliance, lenders require the borrower to periodically report its financial and operational outcomes. Although most sophisticated businesses are perfectly capable of satisfying these reporting requirements, it is not uncommon for borrowers to find themselves annoyed, or panicked, when they discover the administrative cost, these obligations impose.
Covenants matter – timely payment is not enough
Some reading this article may think, “As long as we make timely payments, whether we satisfy these additional covenants won’t matter.” While failing to make timely payments is the quickest way to end up in hot water with a lender, it is not the only way and lenders have increasingly focused on additional covenants and demonstrated their willingness to act on noncompliance.
Financial institutions are businesses that make money in a variety of ways and borrowers should not presume that their lenders will be satisfied with interest and origination fees. In fact, many lenders measure the success of their teams based on the fees and penalties they extract from their borrowers and lenders may also leverage a borrower’s failure to comply with its covenants to force the borrower to modify loan terms, such as by increasing the interest rate or depositing additional reserves with the lender.
Borrowers should be cautious and conservative when negotiating covenants with their lenders. Rather than give in to lender proposals or accept loan documents as “standard terms,” borrowers should carefully review loan covenants and consider whether they can be comfortably achieved. Negotiating ramp-up periods, buffers, and options for curing technical defaults can also provide borrowers with flexibility and wiggle room that can go a long way in avoiding a technical default.
