Working Capital? Or Venture Capital?
July 28, 2010
Often startup and expansion stage companies are faced with a need for either short-term or small amounts of working capital. In these cases, venture capital or expansion capital is sometimes not the best answer (too expensive and too many strings) for management teams.
In these instances, we encourage our portfolio companies and even prospective investments to establish banking relationships and seek out more flexible types of debt (credit lines, term loans) that might make more sense for them than raising another equity round or coming to us for a bridge loan.
As with many relationship-based transactions, it’s always best to build a relationship in anticipation of future needs. Sometimes this isn’t always possible to do early enough, but it sure is more difficult to negotiate a loan on favorable terms with a bank that doesn’t know you from Adam when your company is already running short on cash.
As the Finance Principal at OpenView Venture Partners, I often assist our portfolio companies in establishing and building relationships with banks, as well as helping our portfolio to negotiate debt agreements when necessary. The August 2010 Journal of Accountancy published a great piece, How to Effectively Negotiate Loan Covenants, that reflects many of these same tips.
Preparation is key in covenant negotiation.Covenants are not a one-sided dictate from the bank. While covenants are meant to protect the bank’s interests, it is also in the bank’s best interest to develop a debt instrument that makes sense for your company. For this reason, you should go into the initial discussions with a good idea of the types of covenants that might negatively impact your business. Examples might be restrictions around mergers and acquisition strategy, the effect of income-based covenants if your company is incurring more or more fluctuating losses than prior periods, etc.
Before having the first conversation with your banker, understand your banker’s internal regulatory requirements, and make a list of covenants that you would expect the banker to require from you. Understand how they are constructed and why they might be relevant for your company.
Next, develop a set of realistic covenants from your perspective. Review your financial statements and projections, as well as your strategic plans, to make sure you understand what covenants will and won’t work (and the sensitivity of them). Make sure that you have been diligent in your analysis of your financials and how sensitive your proposed covenants might be to any realistic variations in your projections.
Then, begin a hypothetical discussion with your banker. Once covenants are on paper in a draft agreement, it becomes much more difficult to negotiate them. Try to work through the banker’s and your own expectations before pen is even put to paper.
After you’ve reached an agreement, the docs are signed, and the bank funds the loan, congratulations! But, the relationship doesn’t stop there…don’t ignore your banker!
Proactively work to keep a two-way communication open. This is just good business practice, but it also will be important if the day ever comes when your company is faced with a breach.
Speaking of breaching your loan covenants, it would be wise to implement a covenant monitoring system so that you have an idea when your company might be cutting it close so that you can implement the financial or operational measures necessary to try to avoid the breach.
Despite your best planning and monitoring, however, sometimes an unforeseen business occurrence will arise that results in a breach. Hopefully, since you’ve been talking with your banker on an ongoing basis, this isn’t going to come as a surprise. Your banker’s reaction and the severity of the breach will determine the severity of the penalties. Here again, negotiation is key in order to mitigate the penalties…and it will be a lot easier if you’ve built a strong relationship with your bank beforehand.
For more tips, check out the article in full.