Do your covenants match the level of risk your bank has?  Or are you subject to a common trend in bank covenants?  Here is how it works:

• • In the near term, there is less uncertainty.  Covenant levels are set high.
• • As you go farther out, there is more uncertainty.  The bank sets tighter covenants over time to cover for the risk.  For example:
  • o You are required to have higher EBITDA levels
  • o You have to keep higher interest coverage
  • o You need to show less leverage on your balance sheet
  • o You have to show higher net worth

At first glance, there may seem to be nothing wrong with this.  However, look at it from a different angle.   The bank is probably having you make payments on the debt- revolver, term or otherwise.  Your total bank debt starts at a higher level, then works it way down.

Here is where the problem is, as a former banker put it to me so well.  

• • The covenants are loosest when the bank loans are the highest.
• • The covenants are tighter when the bank loans are the lowest.

The bank has the greatest protection, i.e. the tightest covenants, when their exposure is lower.

Meanwhile, as a company, the farther out you go, the more uncertain you are on your results.  But instead of having more total cushion, you have covenants set much tighter.  You have to be surer of how you will perform at a time you would expect to be less certain.

The fix is to balance out your covenants and the debt level.  Say you have debt of $20MM and an EBITDA covenant of $6MM starting out.  After 3 years, you are to have paid your debt down to $15MM.  Suppose the bank wants to escalate your EBITDA covenant to $8MM.  

What should you look for?  In an ideal world, since the bank debt is down 25%, the EBITDA covenant should drop by 25% as well down to $4.5MM.  Rather than go up, the covenant should come down.

Suppose the bank has their way.  3 years from now, you have grown, but not as much as the bank wanted.  Your EBITDA only climbed to $7MM.  You are technically in default.

But are you really more risky?  If the bank liked you at $6MM EBITDA to lend you $20MM, shouldn’t they like you more at $7MM EBITDA on $15MM debt?

This can happen more often than you think.  In an economy like this, you could be tripping a covenant even though your bank is much better off with you than they were when they took out the loan.

Save yourself some heartache down the road.  Don’t let covenants automatically tighten.  Get breathing room up front by having the covenants match the level of your debt.  Less debt should translate to lower covenants.