Balancing Act: Managing Investor and Lender Expectations in a Down Market

Most companies are highly dependent on investor capital, working capital lines of credit or other forms of bank financing to help fund day to day operations. The capital likely comes with strings in the form of covenants. In years past many companies did not pay close attention to covenants, assuming in the event of a default, that the lending institution would supply the necessary waiver or investors would continue investing.  In today’s economy, covenant waivers and continued investor capital can no longer be taken for granted. Business leaders need to pay attention to their covenants and key financials measures used by investors.

WHAT’S THE WORST THAT COULD HAPPEN?
Failure to pay attention to covenants will negatively affect a company. If not monitored, a company could find itself in a potentially fatal liquidity situation, where the bank is demanding payment of outstanding debt and investors are saying “No!” The decision could become bankruptcy or ceasing critical operations and innovation.

Loan covenants often focus around key financial ratios and measures used to judge the overall financial strength of a company. Common covenants include:

• Earnings Before Interest Taxes and Depreciation and Amortization (EBITDA)
• Current Ratio
• Return on Equity
• Tangible Net Worth

There are several things a company can do to make sure that the business looks as favorable as possible to lenders and potential investors.

UNDERSTAND EXPECTATIONS
Investors and lenders tend to weigh only a few key measures to determine continued investment. Understanding those measures and being able to speak in terms of what is most important to them is invaluable.

PERFORM COVENANT CALCULATIONS FREQUENTLY
Many covenants only require quarterly or annual reporting. However by monitoring them more frequently, a company will gain a better understanding of how day-to-day business decisions are impacting the financial measures, and the perception, of the company.

PERFORM STRESS TESTS
It is beneficial to perform analyses based upon several differing budget scenarios: best case, worst case, etc. This type of stress analysis will allow a company to see its tolerance levels before going into default.

BE PROACTIVE
No one likes to get an unpleasant surprise.  So if you know there are going to be problems meeting your covenants or investor expectations, don’t delay in communicating the issues.  Be honest about the problems but make sure you have a well thought-out response for how the company is going to deal with the current challenges.

Managing covenants can do more than prevent a potentially fatal liquidity situation. Taking the right steps can help strengthen your position as a potential candidate for investment or acquisition while also putting you in a better position to take advantage of an upswing in the economy.

Scott M. Goodwin., CPA is a Member of the Firm at Wolf & Company, P.C. and provides  accounting and audit services to closely-held, venture-backed and publicly traded companies. He can be reached at 617- 428-5407 or sgoodwin@wolfandco.com.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting, tax or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use.  The information in this publication is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this publication. Copyright 2012.