This article originally appeared in the October 2017 issue of Smart Business Philadelphia.

David E. Shaffer, CPA

If you have ever turned to your bank for a loan or line of credit, you know about bank covenants and have agreed to them. A covenant is a clause in the loan agreement that requires the borrower to do, or refrain from doing, certain things.

“These typically get a lot of attention prior to signing the documents, yet become an afterthought the minute the agreement is signed,” says David E. Shaffer, CPA, Director, Audit & Accounting at Kreischer Miller. “However, post signing, we often find that owners have either missed a covenant or have done some action that violates a negative covenant (i.e. the covenant that says that you will only borrow from the bank and you just signed a zero percent loan for a truck).”

Smart Business spoke with Shaffer about the next steps for a company that has violated a covenant agreement.

What's the best way to avoid surprised when it comes to covenant agreements?

The ideal time for a business to talk about bank covenants is when a loan is coming up for renewal or you are negotiating a new loan. Your bank will typically use the financial projections you provide to set the financial covenants. Consider putting something in the loan document that states how you might rectify a missed covenant, such as putting equity into the company, subordinating existing or new debt to shareholders or adding collateral to the loan (e.g. pledging some stock portfolio or cash).

Sometimes, despite everyone’s best intentions, companies fail to meet their bank covenants. When this happens, you should meet the situation head-on. If you are in the middle of the year and believe there is a chance you may not meet a covenant, review current projections to determine what steps can be taken to remedy the situation.

If it is a leverage covenant (debt and/or equity), consider collecting accounts receivable more quickly, or requesting customer deposits to pay down liabilities. Or you might decide to defer some fixed-asset additions until the following year. If it is a debt service coverage ratio and you do not expect to meet the projected income, this can be tougher to resolve by year-end. You can consider deferring owner distributions and/or making contributions so the covenant is met. Be sure to read the definition in the loan agreement.

What if you expect to violate a covenant and are in serious doubt about what to do?

Discuss the situation with your banker before you have violated the covenant. The earlier this discussion takes place, the better. Explain why you might not meet the covenant and ask if it can be amended for just the current year. Remember, your loan officer does not want to have to explain the violation to his or her superiors. If it is the debt service coverage ratio (the most common issue-causing ratio that we see) and you have easily met the covenant in prior years, but something unusual happened in the current year, you will have a much better chance of getting the modification.

If you have already missed the covenant and it cannot be remedied, take the following steps:

  • Notify the bank as soon as possible that you will need a waiver, but only after you and your key advisers have developed a plan to remedy the violation.
  • Provide projections that show you will meet the covenant going forward.
  • Consider putting more equity into the company or adding more collateral to the loan.
  • Request a bank waiver. Keep in mind this could generate an additional fee and some loan terms may be changed (e.g. higher interest rate).

What are some other things to keep in mind? 

Your bank is a key business partner and should be kept aware of what is happening in your business so there are no surprises (good or bad) when financial results are
shared. If you maintain a good relationship, you will be in a much better position to deal with a covenant violation. If you are a new customer and selected the loan based solely on price, the bank’s profit margins are slim and your banker will have much less leverage with his or her superiors to request and obtain a waiver. You may also experience higher waiver fees and an increase to your interest rate.●

David E. Shaffer can be reached at Email or 215.441.4600.

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