Any loan contract or legal agreement will have fine print. However, be aware of three specific restrictions that are used by many that could severely restrict a company looking to borrow funds.
By Chris Fletcher
Most successful companies need to borrow money from time-to-time. Whether it is to buy needed equipment and vehicles, move to a new location, operating capital or for any other reason, credit is part of being in business.
And while recently we have all had interruptions and changes to our norms, business does not stop during the COVID-19 crisis. Companies still need to operate, older machines still need replacing and customers still need work done. Life, and business, move forward.
In fact, in some cases, COVID-19 and the resulting business disruption has made even companies who historically eschewed debt change their thinking a little. In the face of uncertainty, many companies feel it is better to keep their own cash reserves in the bank, and instead borrow to buy equipment or similar. Indeed, in my industry, I have seen this firsthand.
That is what prompted me to write this article. Companies borrowing during COVID-19 may be doing so for reasons outside of their norms and they should be aware of three common “restrictions” (or covenants, if you will) that are a part of many loan contracts.
These restrictions, which are designed to protect the lender, can limit a company even in the best of times. However, they take on even greater importance during COVID-19, because they could unknowingly negate the very advantage that a company doing the financing is seeking. So, here are the three restrictions in more detail. Companies should be not only aware of them, but also insist that they are not a part of any loan or financing agreement.
Restriction #1: A Blanket Lien
The most common restriction, and one of the most limiting, is the blanket lien. Put simply, this is where the lender places a lien on all of the assets a company has. Even future assets can be subjected to a blanket lien.
A blanket lien can severely limit a company’s options. To give a quick example, let’s say a company owns a dump truck. They have owned it for 10 years, free and clear. They then decide to finance a new trailer. The deal goes through, and everyone is happy. Except buried in the finance agreement for the trailer is a blanket lien. This goes unnoticed for a few months … until the company decides to sell its 10-year-old dump truck. That is when the blanket lien comes into play.
You can see where I am going with this, right? The company is not allowed to sell their dump truck, even though they own it free and clear and it has nothing to do with the trailer. They must get the trailer lender’s permission first, which may or may not be given. This is one example, but substitute “dump truck” for anything (or should I say “everything”) in your garage or building.
Bottom line: Blanket Liens are not advantageous to borrowers at all. Borrowers would do better to avoid them, even at the cost of a point or two of interest.
Restriction #2: Minimum Balances
Most banks will not loan money to non-customers. Most businesses generally understand that, and it is why they commonly get loans from the banks they otherwise use. However, typically buried in the loan contract is a “minimum balance” clause, stating the company must maintain a certain balance in the bank. The common number is 80 percent of the loan amount. There are three things to be aware of in this situation:
1. If a company is required to keep 80 percent of any loan in the bank, aren’t they actually borrowing 80 percent of the loan from themselves? Think about it.
2. This clause may be unnoticed by many companies because they do business with the bank in the first place, so they may never get under 80 percent.
3. The ironic part of this involves something I mentioned earlier. Some companies are choosing to borrow to keep their cash in the bank. They are doing this because they may need that cash in an emergency. However, if they have to keep 80 percent of the loan amount in the bank, they are not going to be able to use that cash if an emergency arises. In other words, this clause completely defeats the “let’s finance to keep our own cash in the bank for emergencies” thought.
If you want true financial flexibility as a by-product of any credit deal, make sure minimum balances are not a part of your loan agreement.
Restriction #3: Loan Requalification (and Calling it In Early)
This restriction is one of the more frightening clauses we have seen in loan agreements. Some lending institutions will require a borrower to “requalify” for the loan annually. In this requalification, if something is amiss (say the balance sheet is not as strong as last year’s), the lender has the contractual right to call in the entire loan immediately. Ouch.
In other words, with this restriction in place, if a company takes out a loan, then has an off year, the lender has the right to nullify the loan agreement and insist on payment in full right away. This can absolutely devastate a company and force it to go out of business. It can also limit a company’s flexibility. I have seen buyouts and mergers go south because of this exact clause on a large loan. Nobody wants any part of that clause.
One other reason this can be so damaging to a company is that this restriction is usually combined with the other two I mentioned. This makes it extremely enforceable and provides a company with no room to negotiate. If all of your assets are spoken for by a blanket lien, and 80 percent of the loan amount is locked away, you have nowhere to go.
I realize this last restriction sounds almost draconian in my description, but the scenario I just painted is the exact reason these restrictions exist. They exist to protect the lender, and only the lender.
Any loan contract or legal agreement will have fine print. That is part of doing business. My goal here was to make you aware of three specific restrictions/covenants that are used by many (but not all) lenders, and that these restrictions could severely restrict a company looking to borrow funds.
Talk to your prospective lenders about these restrictions, and if they do exist in their contracts, try and have them removed, or simply find another lender. The restrictions are not there for your benefit and could severely alter your business in the months and years ahead.
Chris “Fletch” Fletcher is a VP of National Accounts at Equipment Financing specialist Crest Capital (Atlanta, GA). Besides being a go-to person for information regarding leasing, financing and taxes, he is also quite fond of music, sports, his dog, and (of course) his wife, who will probably notice she is listed fourth in this bio, but first in his heart. He also maintains the company blog at https://leaseguy.crestcapital.com/, and can be reached at firstname.lastname@example.org. For more information, visit www.crestcapital.com.