Your business’ revolving line of credit (LOC) agreement: a hundred pages of monotonous legalese that independent business owners seldom read, less often understand, and nearly always under-negotiate. Reading a LOC agreement is certain to cause drowsiness, but critical language peppered throughout will affect your business’ ability to survive when unforeseen bumps (whether macroeconomic or business-specific) happen. Lenders and their legal counsel understand the agreement’s importance and meticulously draft its language, which is why you and your advisers need to carefully review, analyze, and negotiate its provisions.
The two primary financial covenants in a LOC agreement are: tangible net worth ratio and fixed-charge coverage ratio. These covenants largely define the performance “box” your business must stay within to remain “performing” on your business loan (and for you to remain in control of your business’ destiny).
Businesses that are able to negotiate significant flexibility in their LOC (and other debt) financial covenants earn a competitive advantage. Tangible net worth provides your lender perspective on how much it can reasonably expect to collect in the event the business is liquidated. Tangible net worth is typically defined as total assets less total liabilities less “intangible” assets.
Typically, lenders want to see tangible net worth of more than $0, which means that theoretically the business could be liquidated to cover all liabilities, including their loan. Changes in this metric are also a proxy for whether the business is generating and retaining earnings over time, so lenders want to see this metric improve.
Your objective, as with all financial covenants, is to negotiate the metric to a level that will give your business maximum flexibility—a covenant that is as low as possible. Ideally, if your business will have substantial tangible net worth pro forma for the loan, you want the covenant as close to $0 as possible. Otherwise, aim to set it at least 25% below your pro forma starting tangible net worth (even if negative).
Fixed-charge coverage ratio’s definition can vary and is negotiable. It is intended to measure your business’ ongoing ability to cover its regular financing commitments. It is often defined as the ratio of (a) EBITDA (earnings before interest, tax, and amortization) less Cap Ex to (b) interest expense plus debt principal payments.
Lenders typically want to see ratios of greater than 1:1 to 1. If your pro forma starting ratio is higher, lenders will often seek to set the starting point at your current ratio. You want maximum flexibility, so you want to negotiate this metric to be as low as possible, at least 33% below your pro forma starting fixed-charge coverage ratio.
The technical nature of these financial covenants illustrates why a team including the business owner or general manager, transaction attorney, and transaction-savvy chief financial officer or financial adviser are prudent to assemble when negotiating a LOC agreement.
-Matt Ogden is managing principal of Building Industry Partners, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. email@example.com. 214.550.0405