Loan Agreements and Debt Covenants: Are you using and monitoring them?

If asked about loan agreements and debt covenants, many community bankers will nod their head and agree that, yes, these are important tools for monitoring the status of loans and the activities of small business borrowers.

But ask them whether or not they are using these critical tools and you might get a different reaction. The fact is, loan agreements and debt covenants are woefully underutilized by community banks on small business loans. Worse yet, many community banks are failing to monitor the loan agreements they have put in place.

Why Banks Resist

There are several common reasons why community banks don’t utilize loan agreements and debt covenants. One is that they don’t want to assume the liability associated with monitoring them. Another is that they don’t believe the loans are big enough to justify the cost and effort required to monitor them. Or, they see that other community banks aren’t requiring them, so why should they?

Perhaps the biggest reason, though, is simply the fact that most community banks don’t want to deal with pushback from borrowers over their perception that the bank is telling them how to run their business. But it’s important to realize that loan agreements are good for both your bank and your borrowers — and to explain this to borrowers who resist them.

From your bank’s perspective, loan agreements build a “fence” around your borrowers that they can safely run around in. They limit their ability to grow too fast and assume too much debt relative to equity, and they limit the ability of owners to take out too much money to support their lifestyle.

Perhaps most important, loan agreements establish upfront expectations with the borrower about the importance of providing ongoing financial information to the bank. This information will enable the bank to monitor their performance and spot potential problems before the business finds itself in serious financial trouble and on the verge of default.

From the borrower’s perspective, loan agreements spell out the terms of the lending relationship in such a way that they are protected from things like new lenders coming in and arbitrarily making changes. Borrowers are also protected if the bank were to be acquired and the new bank has a restricted or prohibited industries list on which they just happen to be at the top.

Make it clear to borrowers that your bank’s objective in requiring loan agreements isn’t to put them out of business if they hit a rough spot. Rather, it’s to identify problems early on so you can address them with the business owner before it’s too late. From your perspective, meanwhile, a loan agreement should enable you to spot these problems while you still have a reasonably cooperative borrower, a viable core business and the opportunity to encourage the borrower to find another bank, if necessary.

Structuring Loan Agreements

When it comes to structuring loan agreements, err on the side of simplicity rather than complexity. If you try to over-engineer them to include every potential scenario that might arise, you will frustrate your borrowers and it will be impossible for you to monitor the agreements. In general, there are six debt covenants that should be included in a typical small business loan agreement:

  1. A requirement to provide periodic financial information
  2. Minimum debt service coverage ratio
  3. Maximum debt to tangible net worth ratio
  4. Minimum current ratio
  5. Minimum working capital level (with step-ups)
  6. Minimum tangible net worth level (with step-ups)

Most automated doc prep programs include templates for standard loan agreements that you can customize for each individual small business loan. Also be sure to clearly state your bank’s definitions for the covenants in your loan agreements. If there is any ambiguity in your definitions, the borrower could use this as a legal defense. For example, there are several different ways that the debt service coverage ratio can be calculated (see sidebar below), so include your bank’s specific definition and formula in the loan agreement.

It’s also a good idea to establish a minimum loan size for which loan agreements and debt covenants will be required. For example, you might require them for small business loans larger than $250,000 with maturities over one year and a total bank exposure of more than $1 million.

The Importance of Active Monitoring

Finally, keep in mind the fact that an unmonitored loan agreement is worse than no loan agreement at all. If you try to exercise remedies against a borrower in a court of law but have not met your obligation to monitor the agreement, the borrower will likely assert that you acted in bad faith by not informing them they weren’t in compliance.

In this scenario, a judge will likely rule that you have implicitly waived your right to default by virtue of your non-action. So if you are going to go through the process of creating and utilizing loan agreements and debt covenants, be sure to put in place a framework for actively monitoring them.

Calculating Debt Service Coverage

It’s important to be specific when defining debt covenants that will be included in your loan agreements. The debt service coverage ratio is a good example.

A minimum debt service coverage ratio (usually of 1:2 or 1:2.5) is one of the most common covenants included in small business loan agreements. But this ratio can be calculated in several different ways. Two of the most common formulas for calculating debt service coverage are:

  1. Net Income + Depreciation & Other Non-Cash Charges / Interest + Current Maturities of Long-Term Debt (Payments)
  2. EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) / Interest + Current Maturities of Long-Term Debt (Payments)

Both of these formulas can legitimately be used to calculate debt service coverage, but they will produce different results. So be sure that your loan agreement specifies which formula will be used for that particular loan.

We can help answer your questions about loan agreements and debt covenants, as well as certify that your borrowers are in compliance.

Contact Sonny MacArthur at (404) 420-5631 or to discuss further.