Commercial Banking Loan Agreements “Everything is Negotiable”
I am working on a new book. I have selected the title but I don’t want to give it away because it is sort of my “intellectual property.” The mission statement of my book is to share information with today’s entrepreneur on how to negotiate various bank loan terms and conditions and how to get your bank loan requests approved 99% of the time. (nobody’s perfect!)
Every loan term in a loan agreement has a cost associated with it, thus it behooves a CEO to know what and how to negotiate each term. The better a CEO can negotiate loan terms the lower their total loan closing costs will be. Loan terms could include but not limited to interest rate, loan fees, collateral, personal guarantees, loan amounts, loan covenants, subordination agreements and the earnings credit rate on the company checking account.
Let’s make this point early……every single term and condition in a loan agreement is negotiable and I mean everything. In my 35 year career as a banking consultant I have seen it all.
The key for CEOs is to be a very strong/bankable company which serves to create a situation where many banks are willing to compete for your business. If you are a weak company you lose your leverage and bargaining power resulting in few if any suitors. How to become a strong bankable company requires a strategic plan which is not the purpose of this article. How to negotiate with bankers is also not covered in this article. It is assumed that as the CEO of your company that you are a good negotiator.
For this article I would like to discuss the loan term of covenants which are generally financial ratios or CPA reporting requirements. In my career as a banking and finance consultant I have found that many of my clients misunderstand the intent or purpose of covenants.
Per dictionary.com the definition of covenant is “an agreement usually formal, between two or more persons or entities to do or not to do something specified.”
In a bank loan agreement the entities are the bank and the business borrower. The covenants as mentioned earlier are generally financial ratios, (Banker KPI’s if you will) and CPA financial reporting. The most common financial ratios that banks use are minimum debt service coverage, maximum debt to equity ratio, minimum current ratio and minimum profitability.
If one bank requires that you maintain a debt service coverage ratio of 1.35 to 1 and another bank only requires a DSCR of 1.10 to 1, the bank that requires the DSCR of 1.35 to 1 will cost you more money in terms of having to pay more taxes as you will have to report a higher level of net income to meet that ratio.
Financial reporting refers to what type and frequency of CPA prepared financial statements the bank requires that the borrower provides. Type refers to compiled, compiled with footnotes, reviewed or audited. There is a significant difference in cost to the borrower between compiled, reviewed and audited to the borrower.
Usually covenants are measured annually but sometimes quarterly. From the banker standpoint covenants are financial benchmarks of a “healthy company.” The intention of the bank is to not make them punitive or to set up the CEO to fail. The administrative time required to address blown covenants is burdensome to banks.
Many CEOs are fearful that if they don’t meet a covenant that the Bank, “will call the loan.” This rarely happens. When a company does not meet a covenant it will prompt a letter and phone call from the banker to have a face to face with the CEO. The agenda for this meeting is what triggered the blown covenant and what corrective action will or has the CEO taken to ensure it won’t happen again.
The key to avoiding blown covenants is negotiating them before you sign that loan agreement. A CEO should never accept them unilaterally. Negotiate the specific covenants, both ratios and financial reporting, so that it works for your company, the bank and your checkbook.