Part of the small print in the stack of papers making up your loan documents is the rules you are promising to follow for as long as the loan is outstanding. These items fall under the headings of default and covenants.
Most loans are secured by collateral. That means if you default on the loan, the lender can take possession of the collateral, liquidate it and give you what’s left after they have recouped their loan balance and fees. Default is failure to make the loan payments. Collateral and default are generally understood by business borrowers.
Covenants vary by the borrower’s credit worthiness, the amount of the loan and the lender’s own policies. The covenants are promises the borrower makes to the lender for the life of the loan. The list of covenants can go on for multiple pages. These generally include maintaining a certain level of debt-to-equity ratio in your business; refraining from buying assets; lending money or distributing money or property to owners of the business without permission from the lender; not taking on any new debt without prior permission from the lender; staying in compliance with the laws relating to the business; not selling the business or the collateral assets without permission of the lender; as well as not using those same assets to collateralize a different loan.
Before you sign the packet of loan documents, you need to understand the limits on your business decision-making power that are coming with the loan. Failure to adhere to any of the covenants puts you in breach of contract, thereby allowing the lender to foreclose on the loan. The obvious covenants like not selling the business are not surprising. What surprises business borrowers is when they can’t finance a new vehicle or piece of equipment without permission from the lender, or when they can’t pay themselves dividends or distributions beyond the limits listed in the covenants without the lender’s permission. If they have a couple bad years, they may find their debt-to-equity ratio has fallen outside the requirements.
A frequent loan requirement is annual financial statements prepared by a CPA. If the borrower is out of compliance with any of the loan covenants, the financial statements have to show the entire loan balance as being due within the next year (current liability). This negatively affects the current ratio which compares your total available (current) assets over the next year to the total current liabilities. Many loan covenants have required levels for this ratio. In addition, the placement of the debt as a current liability on the balance sheet shines a spotlight on the fact the loan is out of compliance.
Most financial institution lenders will work with you as long as they can, but you are at their mercy. The lender has a responsibility to recoup the loan proceeds, which may require foreclosure and possessing the assets used for collateral. In general, foreclosure is a last resort for the lender. Some private lenders can sometimes benefit more from foreclosing on the loan at the first opportunity than waiting for pay-off. With these lenders, it is especially important to understand the covenants of the loan. They may, in fact, want your business and its assets for the bargain price of the outstanding loan balance.
Your CPA or attorney can help interpret what the covenants mean. Getting their help before you sign the loan can help you in negotiating better covenants. Having your CPA or attorney explain the documents even after you have signed them, helps you avoid violating the covenants.
Robin Hayden, MBA, CPA, Certified Fraud Examiner, is a shareholder of Houck & Associates PC. She can be reached at 360.892.4348.