Sometimes provisions in bank agreements with good intentions can end up having unintended consequences.

For example, a client had a clause in their bank agreement that would reduce the inventory portion of their borrowing base if their inventory fell below 90% of the latest inventory appraisal.

The intentions were good.  The bank did not want the company just liquidating inventory in order to keep up with payments on the bank loans.  They wanted to see that payments were coming from real operating performance.

But what if the company put stronger inventory management practices in place?  That happened with this client.  They launched a number of operating improvements that allowed them to operate at the same level of business with lower inventory.

In addition, what if revenues were down?   Shouldn’t the company want to reduce its inventory levels and keep up its cash flow?  What if there is a market like 2008 and 2009 where business is just down in general?   Wouldn’t it be prudent for the company to reduce its inventory levels?

The bank agreement was meant to discourage artificial liquidations.  However, like a medicine with side effects, this clause by itself would encourage the company to keep inventory levels higher than they ought to be.

In this example, the company went ahead and reduced its inventory.  It helped their cash flow tremendously, without lowering their customer service level.  They could still respond just as quickly if not more quickly to customer orders.  Yet despite this, they still had to reduce their borrowing base for the penalty clause in the bank agreement.  It felt like being punished for being good.

Before signing a bank agreement, take a close look at the provisions.  In addition to the covenants, take a close look at the borrowing base calculations on your revolver.  If something does not seem to make sense, ask the banker why it is there.  Maybe there is an alternative version of the clause that can be put in.  Test the provisions with both sales growth and sales declines.  See what happens and if any unintended results can occur.

If you are already in a bank agreement and spot something similar, see if you can renegotiate the particular provision.  You may not have leverage and may have to wait for renewal.  It does not hurt to try, however, particularly if there is a win-win for the bank as well.