Do You Understand Your Loan Agreements?
Trust and transparency matter – in life and in your business. Having spent nearly 30 years in accounting and finance, I’ve certainly experienced many lessons in this regard. At the beginning of the banking portion of my career, I could tear off a commercial note from a pad, fill in the front and back with the company name, rate, and term, have both parties sign, and we were done. A number of years later, I sometimes had in excess of 500 pages of documents necessary to execute a similar deal. What does this mean?
Well, beyond killing more trees or occupying a few more terabytes of storage space in the cloud, it means that it is imperative to have a thorough understanding of your loan agreements. Of course, with a few notable exceptions, no financing provider is out to be purposely opaque in its deals. However, largely due to regulatory and legal pressures, loan documentation can now be quite complex. Here are some key points to consider:
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Line of Credit
What type of loan facility is it – demand or commitment? With a demand facility, there is no defined maturity date, and the borrowings are at the bank’s discretion. A committed facility, there is a specific maturity date. A demand facility is cheaper for the bank, and thus typically less expensive for the borrower. A committed facility carries a higher degree of comfort for the borrower. Both have their advantages.
Borrowing Base
How is eligible collateral defined and what are the advance rates? For example, accounts receivable older than 90 days from invoice are typically excluded, as is older inventory, and retainage. Similarly, how might costs-in-excess or billings-in-excess have an impact?
Job/Project Concentration Limits
Be aware of how a large job or project with a single owner may inhibit your borrowing capacity. It’s best to always communicate with your lender when something out of the ordinary arises. Perhaps discuss a separate financing arrangement for a large, specific project.
Guaranty
If you are required to guaranty your loans, is the guaranty limited, continuing, or secured? Also, does it provide for a spouse or primary residence exclusion? All are important points to consider.
Collateral
How is the loan collateralized? Is there a blanket lien or specific asset filing? Be particularly aware of cross-collateralization – this can place additional assets at risk, however, it may also allow you to achieve better rates and terms. Similarly, are outside ventures co-mingled with a cross-guaranty or cross-collateralization clause? I’ve seen issues with outside real estate investments (un-related to the core operating business) cause defaults with perfectly healthy businesses. Best practice is to try to wall-off investment real estate. Seasoned developers, in fact, try to do this with every separate project.
Covenant definitions
Debt service coverage vs. fixed charge coverage, net worth (tangible or GAAP), working capital, leverage, etc. With covenants, it’s best to understand precisely how they are defined and when they are tested. Covenants provide a measure of discipline, but the true purpose is to get both parties back to the table to discuss a significant change in the operating profile.
Hidden risks
Asset sale/purchase limits, change in control vs. change in ownership, material adverse change clause, cross-default, swap agreements, change in law/statute. Any number of these may come in to play. I’ve seen unfortunate situations whereby a change in statute created a technical default for a borrower. Generally, these can be avoided with good up-front communication and understanding on both sides.
Ultimately, a thorough understanding of your loan agreements can help de-risk your business and thus add value for you when you look to grow – either through purchasing additional equipment or real estate, or perhaps an acquisition or liquidity event. In my view, it is Best Practice to arrange a sit-down with your financing provider, surety provider, and CPA together. Both are there to help you be successful, and transparent communication with all parties in the same room generally fosters tremendous ideas and benefits for your business. Give us a call to help provide this guidance.
By: Doug Houser, CEPA, MBA, principal & director of construction & real estate services
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