When searching for a debt provider it’s often tempting to sign up to the first lender that agrees to finance you (or even the cheapest). There’s nothing wrong with either of those strategies if they work for you. There is however something in the terms and conditions that the lender will explain to you but – in my experience – business owners’ eyes will glaze over. Careful what you sign up to.
By law, the lender is also obliged to advise you to seek independent legal advice. Again, the business owner just wants to sign up and get his/her money. Borrowers should pay particular attention to Covenants. These are obligations placed upon the borrower that are contractually enforceable by the bank. If you fail a covenant you can be in breach of the lending agreement. Careful what you sign up to.
What happens next? Best case: The bank sends you the breach notice and usually reserves it’s rights to take action against you. While no action is taken against you at the time, the bank has reserved its rights to act against you in the future because of the initial breach. Not life threatening in of itself but – as they say in Seinfeld – the bank has hand. Worst Case: The bank can ask for its money back by a certain date. If you fail to pay, the bank can liquidate all securities to satisfy the outstanding debt. If securities granted are insufficient to extinguish your debt obligations, the bank can also become an unsecured creditor until you satisfy the debt.
The second phase is unusual as most business owners have been bankrupted (either voluntarily or by the bank) by the end of the first phase. Careful what you sign up to.
Firstly, let’s explain the operational covenants like providing financials on a regular basis. It’s not unusual for banks to want to stay on top of your business to ensure that their money is not being placed at risk. If they ask for quarterly or monthly management accounts – usually within a set period after the balance date – make sure you can operationally provide them. If they ask for your annual financials 45 days after the financial year end and your business typically takes six months, make sure you can adjust otherwise you may be issued with a breach notice – which may lead to the bank asking you to refinance elsewhere. Careful what you sign up to.
Financial covenants are another way that business owners fall into some traps that are unintentionally set by banks. A common mistake is for business owners to sign up for a Debt Service Cover Ratio (or DSCR) at a certain level. In the year after signing the loan documents, the hard working business owner repays more than they are contracted to so that they can quickly reduce their debt balance. There’s one problem with that – the bank will use the extra repayments in its debt service calculations. One way of overcoming this is to contractually exclude those extra repayments from the calculation. Careful what you sign up to.
To ensure that financial covenants are not going to be a problem in the future, you need to sit down with your accountant and calculate what they currently are and what they may be in 12 months time. Then, don’t be shy to negotiate with your banker if one or more of them is too close for comfort.
An example of financial covenants catching business owners unawares was during the GFC. There was a period when some major banks got very nasty. Asset prices were depressed briefly and the banks used this period to re-value the assets pledged as security by borrowers. If the borrower had a Loan to Valuation covenant (using just one example) and the new valuation meant that the borrower was in breach, banks issued a breach and in some cases asked for their money back.
Perfectly legal, if somewhat immoral.
Be careful what you sign up to. You always have a choice. If you’re not sure, seek professional help.