You have just received a letter of intent outlining the terms of a bank line for your company. Interest rates have climbed quickly, and banks are tightening their credit standards as they await the next recession. You are thinking: is this the best deal we can get?
Currently a profitable, privately owned company with a good balance sheet will be looking at 50 to 150 basis points over prime rate. There will be 3 to 5 key loan covenants that restrict cash outflows and balance sheet changes. There will also be a 1% loan fee paid up front. So, should you try other banks? Before you do, here are some important things to consider.
First, shopping multiple banks hurts your FICO score and you are not likely to see much difference in terms. Secondly, if you have an established banking relationship, now is the time to strengthen it rather than abandon it. Most business owners focus on the cost of the loan rather than the structure of the loan which can cause them to miss the most vital details of the loan covenants.
Loan covenants can restrict how you run your business and your own personal financial plans, so heads up on those details! Debt service coverage ratio (DSC) and debt to net worth ratio (DTNW) will require you to keep more cash in the company to meet minimums. For DSC 1.25:1 and DTNW 3:1 and there may be resting requirements. Here are the definitions of these covenants, pulled right from a loan agreement provided by our friends at InBank:
TRADITIONAL DEBT SERVICE COVERAGE RATIO. BORROWER SHALL ATTAIN A RATIO OF TRADITIONAL CASH FLOW TO DEBT SERVICE OF NOT LESS THAN (VARIABLE) TO 1.00, TESTED AT THE END OF EACH FISCAL (VARIABLE) FOR THE PRECEDING 12-MONTH PERIOD. “TRADITIONAL CASH FLOW” MEANS NET INCOME AFTER TAXES AND EXCLUSIVE OF EXTRAORDINARY GAINS AND LOSSES, GAINS ON SALE OF FIXED ASSETS AND OTHER INCOME, PLUS DEPRECIATION, AMORTIZATION, RENTS AND LEASES, AND INTEREST EXPENSE, LESS DISTRIBUTIONS. “DEBT SERVICE” MEANS THE SUM OF INTEREST EXPENSE, CURRENT MATURITIES OF LONG-TERM DEBT AND CURRENT MATURITIES OF CAPITAL LEASES AND RENTS, (ALL CALCULATED FOR THE PRECEDING 12-MONTH PERIOD).
TOTAL DEBT / TANGIBLE NET WORTH RATIO. BORROWER SHALL ATTAIN A RATIO OF TOTAL DEBT TO TANGIBLE NET WORTH OF LESS THAN (VARIABLE) TO 1:00 ON (VARIABLE); (VARIABLE) TO 1.00 ON (VARIABLE); (VARIABLE) TO 1.00 ON (VARIABLE); AND (VARIABLE) TO 1.00 ON (VARIABLE) AND THEREAFTER, TESTED AT THE END OF EACH FISCAL (VARIABLE). “TOTAL DEBT” MEANS ALL OF BORROWER’S LIABILITIES INCLUDING SUBORDINATED DEBT. “SUBORDINATED DEBT” MEANS INDEBTEDNESS AND LIABILITIES OF BORROWER WHICH HAVE BEEN SUBORDINATED BY WRITTEN AGREEMENT TO INDEBTEDNESS OWED BY BORROWER TO LENDER IN FORM AND SUBSTANCE ACCEPTABLE TO LENDER. “TANGIBLE NET WORTH” MEANS BORROWER’S TOTAL ASSETS EXCLUDING INTANGIBLE ASSETS (I.E., GOODWILL, TRADEMARKS, PATENTS, COPYRIGHTS, ORGANIZATIONAL EXPENSES, AND SIMILAR INTANGIBLE ITEMS, BUT INCLUDING LEASEHOLDS AND LEASEHOLD IMPROVEMENTS) LESS TOTAL DEBT.
RESTING PERIOD. BORROWER SHALL REDUCE THE AMOUNT OF SHORT-TERM INDEBTEDNESS OWING TO LENDER TO ZERO ($0) FOR AT LEAST 30 NON-CONSECUTIVE DAYS, DURING EACH FISCAL YEAR.
These stipulations may make your eyes roll but must be fully understood because of their impact on how you run your business! The cost of the loan is secondary to your decision, and it is important to model the impact into your business plan. If you have a forecasting model, look to see if you will meet these covenants over the next year. If you do not have a model, look at your financial history over the last 2 years to see if you can live with these covenants.
YOUR BEST LOAN DEAL IS THE ONE THAT GIVES YOU THE MOST FLEXIBILITY IN RUNNING YOUR BUSINESS.
C Squared Solutions provides interim or fractional CFOs, COOs, and CEO advisors in nearly all industries. We analyze and advise on these issues frequently through sophisticated modeling and experienced management. Give us a call or visit our website for more information and details. We have been there and done that!