Second of two parts. Read Part 1 here. If excessive debt was the Great Recession’s No. 1 killer of pro dealers, losing control of one’s business to a lender more often than not put the nail in the coffin. Financial leverage, mixed with declining sales and operating profits, evaporates a business’ equity value, net earnings, and cash flow. But despite challenging circumstances, a business can fight to survive so long as it has the power to act. It’s typically not until a lender seizes control and imposes its will that the business’ fate is sealed. The risk of losing control of one’s business to its lender is a hidden cost of debt that is far more deadly to a business than its interest cost or fees. Fortunately, like financial leverage, this risk can be reduced, although not eliminated.
Most business owners understand that when they raise equity capital (particularly when selling majority ownership), they give up sole control over their business’ destiny. However, most owners also believe that when they raise debt capital, they retain this control. This is true only when things go well. What owners fail to appreciate is that by taking on bank or other debt, if their business performs poorly, they can lose control of the business to its lender.
When times get tough, lenders’ incentives and actions focus on protecting their loan principal at all costs. This is reasonable because lenders provide relatively low-cost capital and need the ability to protect their “senior,” lower-risk cash flow and asset tranche. But lenders’ incentives can conflict with maximizing a business’ long-term viability and equity value.
Furthermore, you cannot predict your lender’s future attitude toward your business. Banks’ perspectives and circumstances change. Your current banker (or even that bankers’ bank) may not be around when your business needs concessions. These conflicts of interest between equity and debt and uncertainty around banks’ future view of your business demand you mitigate the possibility of losing control.
Your rights to stay in command are outlined in your loan’s credit agreement (aside from stated interest rates and perhaps fees). Its financial covenants define the threshold above which your company’s performance must remain in order to avoid a default. Once your business is in default (aka “non-performing”), the lender controls your business’ destiny. Therefore, you must negotiate the loosest covenants possible.
The loan’s collateral advance rates also dictate how much liquidity your business will have access to during its loan term. That’s particularly crucial when times are tough. Negotiating the most favorable advance rates (including ineligible and other carve-out provisions) is critical to maximizing your business’ access to cash, and therefore your power to conduct business without voluntary concessions from your lender without sharing or relinquishing power or control to the lender.
These risks of debt don’t outweigh debt’s benefits, but they do need to be understood and appreciated. Negotiate prudently. Lawyers and accountants can bring their expertise to bear for you during a loan transaction process, but rarely do they have the financial expertise to effectively negotiate critical covenants, advance rate and other financial provisions. Turn to a seasoned CFO or transaction adviser to serve as prudent allies.
-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. E-mail: firstname.lastname@example.org. 214.550.0405