How loan covenants can help you and your bank manage your transactions

Risk is part of the game when you’re making bold moves that you hope will lead to the growth of your business.
But it’s a much different story for the person who works at a bank and sits across from that eager business owner looking to make those bold moves.

“Banks are not in the business of placing big bets on the chance of making up the difference with a potential big win,” says Rob Fernandez, senior vice president and team leader in Bridge Bank’s Technology Banking Division in San Jose.

This differs from the mindset of venture capital investors and that dichotomy between investor and lender business models is something that often requires some education when an entrepreneur is seeking capital.

Sometimes a borrower will have the perspective that if you believed in their business and you were supportive of it, you would be willing to take greater risk.

“My response is usually to inform entrepreneurs that equity is for higher risk capital, debt is better suited to sustain growth and sometimes to extend the runway to subsequent financing rounds,” says Fernandez.

“Most technology-focused lenders have the ability to provide what’s known as ‘venture debt,’ or ‘growth capital,’ but those facilities rarely take the place of true equity capital in the financing mix.”

One of the tools banks use to evaluate risk in a transaction over time is the loan covenant.

Smart Business spoke with Fernandez about how banks use covenants to set financial guidelines for business loans and what borrowers can do to build stronger relationships with their banker.

How do loan covenants strengthen your relationship with the bank?

Financial covenants are set to let the borrower and lender know when it’s time to ‘have a conversation.’ Some financial managers fear that if they trip a covenant, the bank will suddenly take a very risk-averse position, possibly calling the loan. Very often these events can be managed or resolved in a manner that allows the company and bank to move forward and maintain the relationship. If your business is 20 percent off of its revenue plan, you and your banker should be having a conversation about what’s going on in the business. The earlier that conversation happens, the easier it is for your banker to do the work necessary to advocate for the company.

Ideally, the covenant will be set to trigger in advance of what might be a dramatic change in business performance.

Are there risks banks are willing to take?

Banks are willing to take on reasonable risk, but they are not in the business of rolling the dice. They want to help your company grow by providing their kind of financing, based upon an informed view of your business. If you wait until the 11th hour to provide crucial information, knowing all along that you were going to encounter a problem, the banker may naturally lose confidence. So, a covenant should be viewed as a tool for both parties to keep the relationship healthy. Trust is built and confidence is maintained when there is open and honest communication.

What are some keys to selecting the right lending partner?

Select a banker the way you select any key business partner like a CPA or attorney. You need a banker who will provide guidance and assistance, someone who will anticipate your needs and understand what’s going on in your business. The best financial partners strive to see in advance the things that would help you manage your business, improve operations and profitability.

The best bankers will think proactively on your behalf, ‘The company is sending X dollars to India monthly to support an R&D team. I wonder if they are managing that foreign exchange risk and cost in the most efficient way possible. We should offer to consult with them on that.’

Experienced financial managers love to have someone show them something that he or she had never thought of before. Pick a banker who knows your business and is experienced enough to be a real partner. A commercial bank is not just a place to put your cash. You want somebody who is going to be an instrumental part of managing your business.