Your Covenant Calendar: Four Critical Dates To Optimize Debt And Avoid Default
Your business loan agreement has key dates. How you manage them can make the difference between a good borrowing experience and a debt disaster. The successful business borrower focuses on the critical dates during the loan negotiation process. The covenant compliance bell is hard to quiet after being rung. Loan waivers can be time consuming, messy and expensive. Be a smart borrower and understand the key dates in your business loan agreement.
The loan term is the length of time you will borrow money from your lender. Your loan agreement will have a fixed date in the future for complete repayment of the outstanding principal plus any accrued interest and fees. The maturity date is a key milestone in your loan agreement. Make sure you negotiate enough time for the loan collateral to appreciate or for completion of project development. The collateral should, in theory, grow in value during the loan term if your strategic plan is accurate and executed correctly. Be ready with a source of take-out financing on the maturity date. The maturity date refinancing should provide for enough excess loan funds to pay for closing costs. Strategically plan loan maturity dates to avoid having too much debt roll in a single year.
Your loan may contain extensions beyond the maturity date. Extensions are common in floating rate loans. You may be entitled to several one-year or multi-year extensions after you achieve certain hurdles. Extensions are important to ensure there is enough loan term to complete development and income stabilization of your project. Each extension usually requires an extension fee expressed as a percentage of the loan amount being extended.
Interim achievement dates establish certain financial or non-monetary performance benchmarks. The bank may require a financial or restrictive consequence for failure to meet the interim achievement hurdle. A loan re-margin or principal reduction is one of the remedies lenders use to enforce compliance with the milestone covenants. Get the right to re-margin the loan to a level that meets the test instead of a full loan repayment. The lender imposes these benchmarks to get comfort that their loan security value is improving. Loan covenants can work to your advantage too. You might negotiate an interest rate or spread reduction upon achievement of a certain financial or non-monetary hurdle. The repayment guaranty may also be reduced on a certain date and with collateral conditions. Keep track of these important dates in your loan servicing calendar to capture every available financial benefit in the loan agreement.
Fixed rate loans can be amortized, or repaid, over any period agreed to by the lender and borrower. Typical amortization periods are 15 to 30 years. Amortization comes from the Latin word meaning to put to death. Essentially the borrower retires or puts to death the principal balance of the loan over time. A longer amortization period has lower periodic loan payments which increases your business cash flow because less money is going to pay monthly debt service. Lenders often require shorter amortization periods for riskier borrowers and collateral because they want to get paid back sooner. Credit cycles also play a role in the lending standard for amortization with financial market crises driving amortization toward shorter periods. Some lenders are willing to write loans that have all or part of the loan term on an interest-only basis so ask for this provision.
Your loan may have restrictions on when prepayment is allowed and the associated penalty. A loan may be locked out entirely to prepayment for the first few years of the loan term and then be open with a prepayment penalty based on yield maintenance or defeasance. The prepayment provisions are designed to preserve the lender’s yield on its investment in your loan. The prepayment restrictions will hinder your business flexibility if you need to pivot quickly out of the loan. Try to negotiate an open prepayment period without a penalty at the end of the loan term. Three to six-month open prepayment windows are common in commercial loan agreements. Also, be sure your prepayment penalty calculation excludes any open prepayment period in the loan agreement. You shouldn’t pay a penalty on the period where you wouldn’t otherwise be charged a premium.
These are just a few of the key dates in a commercial loan agreement. Make a loan servicing calendar so you can track these dates and avoid a covenant compliance oversight which could result in a loan default and financial penalties.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advance your business ability with our proven executive coaching, objective management consulting and dependable financial services.
Collateral Chains, Cash Restraints And Waterfall Buckets! Are You A Business Prisoner Of Loans?
A commercial lender has many ways to restrain the borrower. Business movement can be hindered with restrictions in the loan agreement. The lender can get intrusive rights over the collateral and business operations. Here are some of the biggest lender controls on a borrower and some suggestions for preserving your business operating freedom.
The Collateral Shackle: Lenders want to have as much security as possible for a loan because it reduces their repayment risk. Borrowers are too eager to give up loan collateral out of ignorance or ambivalence. Lenders often require security beyond the asset being financed and sometimes require cash deposits as additional collateral. What is the appropriate risk adjusted rate of return for the lender if they have cash or near cash collateral securing the loan? Closer to Zero %?
Limit the pledged collateral to the asset being financed especially if it generates sufficient cash flow to cover debt service. Avoid cross-collateral arrangements where an unrelated asset is pledged as security. If you default on the loan you may lose both assets. Watch for spreader clauses that automatically capture new borrower property as it is acquired. Negotiate specific collateral release provisions if you need to sell or otherwise remove the debt on part of the security during the loan term.
The Reserves Straight Jacket: Loan reserves are an especially insidious way lenders control borrowers. Reserves for capital improvements, operating expenditures, insurance and taxes are common in many loans. The borrower is forced to go through time consuming requests for the release of reserve funds for reimbursement of costs already paid. This creates an additional cash requirement that may be difficult to source. The lender sometimes requires the reserves to be on deposit at their bank which increases fee and interest income. The reserve deposits are hard cash that is additional security for the loan. Try to eliminate reserve requirements whenever possible. Negotiate the right to receive interest on your reserve deposits. Capital market conditions, lender competition, sponsor quality and the loan collateral all determine what reserves and funding levels are required.
Cash Management Cuffs: A lender fastens metal bracelets through the control of cash into and out of the borrower. Cash management provisions give the lender an additional source of security. A typical cash management agreement may have multiple levels in the sweep account structure, defined cash waterfall buckets and triggers for even more borrower restrictions. Be aware of any cash trap trigger events and make sure you have sufficient cushion before these would come into play. Negotiate the use of your existing cash management account structure to avoid opening new deposit accounts which cost your company time and money. Limit restrictions on borrower distributions of cash whenever possible.
Prepayment Prison: The lender looks for a guaranteed yield on its investment in your loan. A prepayment causes the lender to redeploy its cash into new loans which may have a lower yield depending on market conditions. The prepayment penalty creates a disincentive for the borrower to pay off the loan early. Penalties come in several popular flavors including a yield maintenance premium and defeasance.
Yield maintenance is a predefined formula in the fixed rate loan agreement which uses the current bond market yields to discount the remaining loan payments in the term. If current market interest rates are lower than your loan interest rate then the yield maintenance premium will be positive. If market rates are higher than your loan interest rate then the formula returns a zero premium. However, the lender usually writes a second test with a fixed percentage of the outstanding loan balance so it ends up with a premium in its pocket anyway. Floating rate loans can have spread maintenance premiums and both types of loans can have prepayment lock out periods where any prepayment is prohibited.
Commercial mortgage backed securities (CMBS) typically use a defeasance calculation which allows for replacement collateral in the form of notes and bonds to be purchased and pledged. The future payments from the securities closely match the future loan payments to make the lender or investors whole. Experienced capital markets advisory firms are available to assist with a defeasance transaction.
Avoid the biggest restrictions found in many commercial loans. You want to operate your business with minimal interference from the lender. Make sure you hire an experienced attorney for your loan transaction team with the goal of preserving your business operating freedom.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advance your business ability with our proven executive coaching, objective management consulting and dependable financial services.
Alphabet Finance: How To Calculate The Return On A Business Investment
You have a plan to strategically invest your business capital. You want growth in sales and value for your company and you have identified one or more opportunities to deploy your company’s cash and accomplish your business objectives. How can you identify the most financially attractive investment? Make the right choice and your business will bloom with new revenue and added value. Make the wrong choice and you will spend years untangling from an unwise investment and incurring substantial financial losses.
There are three primary methods of evaluating the financial return of a capital investment. You can look at a static or pro forma return on investment (ROI), an internal rate of return (IRR) or the net present value (NPV) of an investment. Actually, you can use all three methods to have a more complete financial picture. There are other less useful but widely used methods to evaluate the return on an investment such as calculating the payback period. This article will look at the three most useful methods previously mentioned.
The easiest and most common method to evaluate a business investment is by calculating a static pro forma return on investment (ROI). The word pro forma comes from the sixteenth century Latin word meaning as a matter of form. The pro forma return calculation looks at what will be when the investment is fully operational or stabilized. This calculation ignores the planned ramp up period for the strategic investment but takes into account any operating capacity slack at stabilization. Time value of money is not a consideration in the pro forma ROI calculation. In other words, if it takes several years after you make the investment to begin generating profit there is no discount for the delay in investment return. Time value of money is a financial principle that a dollar today is worth more than a dollar tomorrow due to expected or realized inflation. To calculate a static ROI simply take the expected stabilized net operating income divided by the expected costs to acquire and improve the investment. You can evaluate competing capital investment opportunities using ROI because all the calculations are made using dollars at today’s value.
The Internal Rate of Return (IRR) calculation takes into account the time value of money. As mentioned above, time value of money is a financial principle that a dollar today is worth more than a dollar tomorrow due to expected or realized inflation. In other words the longer you have to wait for an investment to return a dollar the less it is worth to you today. The IRR calculation takes a series of investment inflows and capital outflows and returns the average annual rate of return over the investment period to yield a zero net present value (NPV, see below). For example, an investment that has a ten-year time horizon might return a 10% IRR which is the average annual return of the investment. Some years the return will be higher and some years it will be lower. IRR is useful for comparing strategic investments that have the same time horizon but different planned cash flow streams. It also provides clarity because it discounts future cash flow.
Net Present Value (NPV) is the cousin of IRR. The differences are with IRR you solve for the average annual return to get a zero NPV while the NPV calculation shows the value in today’s dollars from a series of future investment flows. You need to determine the annual discount rate to solve for the net present value for your investment opportunity. This involves substantial guesswork and is prone to error so be careful when selecting the discount rate to apply to future cash flows.
The last word is about positive and negative leverage. You should evaluate an investment on an un-leveraged basis first, that is before considering any debt financing. Loans add an extra layer of complexity with multiple variables subject to market forces outside of your control. An investment that has a rate of return greater than the expected loan interest rate generates positive leverage. If the return on investment is less than the loan rate then you have a negative leverage situation. Leverage is a double-edged sword with a positive edge that will help you conquer your business goals and a negative edge that will hack your company to pieces.
Choose carefully from among your investment options during your financial planning process. You have a finite amount of disposable cash for growth opportunities. Your strategic investment plan should include a calculation of return on investment (ROI), net present value (NPV), and internal rate of return (IRR) for each business opportunity.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advance your business ability with our proven executive coaching, objective management consulting and dependable financial services.
Avoid The Business Ditch: Understanding Financial Performance Indicators
Countless executives operate with little or no understanding of their company financial performance. Sometimes they survive or thrive in spite of their lack of knowledge. Other times financial blindness leads to a wrecked company. Do not leave the money matters to the accountants. Business leaders in all functional areas can improve their chance of positive personal and business growth by establishing a basic understanding of financial performance indicators.
Running a business is like driving a high performance sports car. The person behind the wheel needs to scan and react to the dashboard instruments. Imagine you are driving your company down a beautiful country road and admiring the majestic lending trees, hypnotic marketing vistas and ethereal information technology clouds. But you are unaware that the company financial engine is overheating because you did not watch the instruments on your data dashboard. The breakdown could have been avoided by scanning, evaluating and responding to changes in the primary financial indicators.
The most important indicators on the financial dashboard are operating ratios. The ability to turn fixed assets, raw materials and inventory into cash is reflected in various indicators including the inventory turnover, sales-to-assets and accounts receivable ratios. These are top line indicators that reveal the general operating strength of your company. These ratios show how much revenue you generate relative to your assets, how quickly you convert assets into sales and how soon those sales are turned into cash.
Liquidity ratios are another important set of financial indicators. Every company needs the ability to pay bills as they become due. A company that does not have enough liquid assets to pay current liabilities will quickly find financial trouble. Suppliers will demand quicker payment and deny credit that can be company lifeblood. The current ratio indicator shows how many times the company can cover or pay the bills that are coming due within the next year. Current assets such as cash, short term investments and sometimes inventory can be quickly converted to cash for bill payment. Generally, current liabilities are those due within the next twelve months. The quick ratio only looks at assets that are cash or nearly cash and how many times that amount can cover bills that are immediately due. Both of these ratios should be greater than one-to-one or you may soon find yourself unable to pay your bills.
The next set of indicators tell us how much money your investment in company assets is returning. Generally people start or buy a business to make a profit. The return on assets indicator shows the amount of net profit on each dollar of assets. Some of those assets are purchased with equity and debt so the return on equity ratio reveals how much positive leverage the company is generating with borrowed funds. The goal is to generate a high enough return on the investment in the company to compensate for the risk and to match or beat the return of your industry competitors.
The last major category of performance indicators is leverage ratios. Debt can be a powerful tool to grow a business and create positive leverage. But debt used incorrectly can put your company into an unrecoverable skid. Stay away from credit crises. Keep a close eye on your leverage by using debt-to-equity, debt-to-capital and debt service coverage ratios. Your ability to comfortably service debt depends on the result of operations and liquidity. Closely monitor the change in your leverage ratios to make smart debt capital choices.
After you have calculated your operating, liquidity, profitability and leverage ratios the next step is to track your results across time periods and against industry competitors. Time-series analysis looks at the changes in financial indicators across similar time periods. Compare a month, quarter or fiscal year to the same period earlier. Cross-sectional analysis compares your financial indicators with industry competitors. Private companies tend to be secretive with their financial data for obvious reasons so it might be impossible to compare results. Instead, find the publicly traded company that leads your industry and evaluate their financial results for a general idea of the industry standard.
You can learn to calculate and understand basic financial statement indicators including operating, liquidity, profitability and leverage ratios. Monitor your financial engine across time periods and against competitors as you safely navigate the twists and turns of the roads in your industry.
Michael Shelton is President and CEO of Shelton Business Services which provides executive coaching, management consulting and financial services. Call 602.463.1199, email [email protected] or visit sheltonbusinessservices.com Advance your business ability with our proven executive coaching, objective management consulting and dependable financial services.
Tips for Reg D Securities Filing: Get Help with Blue Sky Requirements & Investment Laws in Any State
Speculative claims are danger zones for exploitation and fraud, hence the necessity of securities laws. Imagine someone trying to sell a “few feet of blue sky” and you have the essence of what the first drafters of first Blue Sky law to a 1910 Kansas statute. Today we have what are known as Blue Sky Filing: forms required by each state when a business owner collects investment capital from a particular state. Each state has their own process and fee and because filings are required within 15 days of each receipt of capital, investors are under the gun to get their forms in quickly and accurately.
In a securities context, the Blue Sky Laws seek to prevent speculation and vanishing thin air promises.
Securities “backed by nothing but the blue skies of Kansas” were as frightening in 1910 as they are now. After Kansas passed their statute other states began to follow suit. In 1917 the U. S Supreme Court addressed the constitutionality of state securities laws Hall v. Geiger-Jones Co. The court held that each state had the power to regulate the offer, sale, and purchase of securities. While many of the statutes and securities laws pertain to the federal level, state laws that govern the issuance and trading of securities are known as the “Blue Sky Laws”. It is the requirements of the individual state that you must adhere to for blue sky securities filing.
Investors may need to get help with their states Reg D Securities filing and Blue Sky Requirements.
It is not unusual for business owners to require state-by-state help to make sure they are complying with every aspect of legally accepting capital. Services like Reg D Fast are designed to help with state filing requirements quickly. Using a service is one way to significantly simplify the process while gaining the peace of mind of knowing you are being thorough with the legalities of securities filings. They locate the forms you need to file (for multiple states if necessary) and send them back to you to review and approve.
You can avoid using an expensive attorney for Blue Sky Filings.
Paying an attorney to help with the documents and filing processes for accepting business capital under Regulation D can be extremely cost-prohibitive. An online service that offers live help and networking, as well as research for the forms and states you need to file within can save a new business thousands of dollars.
Written by Mike Regd
“http://www.regdfast.com”