Today’s business credit remains very tight. Banks making senior loans to established companies are now conducting more extensive due diligence on prospective borrowers than ever before. Although every bank has a different checklist of things to examine, historical financial performance numbers are extremely important in every loan process.
After due diligence is completed, your banker will recommend loan covenants to further protect the bank. Loan covenants are written into the loan agreement and require you to do certain things like provide financial statements to a lender on a monthly or quarterly basis. They’re normally pretty reasonable (though not always) and help the bank monitor your loan and your business so they know your business is in good health.
Banks also pick a few financial ratios to measure, usually on a quarterly basis, that your company is required to meet. Typically they pick a liquidity ratio, a leverage ratio, and perhaps a debt-to-equity ratio.
Ideally, your banker has looked at your historical performance ratios and set covenants that make sense for your business. These covenants have agreed upon definitions and are easily measured.
Nearly all loan covenants are negotiable, both in terms of including and excluding individual ones from loan documents, but also in terms of the actual financial ratios you must maintain.
Most measurable covenants require you to be out of compliance for two consecutive quarters before your loan can be placed in a “default” status.
The kinds of covenants you want to avoid at all costs are ones that are vague in their language. One vague subjective loan covenant you want to avoid is one that places you in loan default for “material adverse changes” that may occur in your business.
A good practical definition is provided by The Practical Law Company: “a material adverse change in the business, assets, properties, liabilities (actual or contingent), operations, condition (financial or otherwise), or prospects of the borrower, individually, or the borrower and its subsidiaries taken as a whole.”
The “material adverse change” type of covenant is very subjective and can’t be easily measured. It also can be exercised at nearly any time and totally at the lender’s discretion.
Examples of events that can trigger a default under a material adverse change covenant include:
- A critical member of management leaving the company
- A court ruling against your company on an intellectual property dispute
- The discovery of prior period accounting postings that change the overall picture of the company today
- A natural or man-made disaster that has affected your business
Unfortunately, it’s easier to say what is material rather than to say what isn’t material, and that’s precisely why you should work hard to modify the standard loan document boilerplate.
When negotiating with your bank, it’s often possible to “carve out” certain events that can be defined as not being material. Here are a few examples:
- Changes in general political, economic, or financial market conditions
- Changes in industry conditions that don’t disproportionately effect the target company
- Changes resulting from the announcement of the transaction
- Changes resulting from the parties’ compliance with the terms of the agreement
- Changes in generally accepted accounting principles
- Changes in law
- Acts of terrorism or war
Material adverse change covenants can place a growing company in jeopardy. While it’s not always possible to remove this covenant completely, it’s possible to modify it to lessen its vagueness and make it more tolerable. It should go without saying that you should never sign loan documents unless you’ve fully read them and completely understand them. If you don’t completely understand them, then it’s important to seek the advice of your attorney or trusted advisor.