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Thoughts on Small Business Lender Covenants

Ben Chang's Profile

I have recently moved to a small business (less than $20m in revenues) and am used to seeing bank covenants use trailing 12-month earnings (EBITDA) as a measure for leverage and debt service. However, our current covenants are using tangible net worth to measure leverage. I am curious about two things: 1) Why would the lender use this as a measurement? Tangible net worth penalizes the business for having taxable profits as S-corp tax distributions effectively reduce net worth. 2) At what level should of revenue/assets should I expect a lender to start looking at earnings as the primary measurement for covenants.


Topic Expert
Wayne Spivak
Title: President & CFO
LinkedIn Profile
(President & CFO, |


Lenders are very wary providing money to small firms for several reasons. At the top of the list is that money; lent for working capital; is finding its way into the owners pockets (salary, bonus, expenses). Let's not forget that a majority of small businesses fold, etc.

I'd say $50M, but this is not hard and fast and mileage will differ based on region, industry, lender experience within industry and with company, relationship with company and faith in leadership,etc.

Ben Chang
Title: Director of Finance and Accounting
Company: Transportation & Logistics
(Director of Finance and Accounting, Transportation & Logistics) |

Wayne, I appreciate the comments.

You are correct regarding the lenders concerns with their money finding their way into non-business items. They have covered this off, at least partially by restricting owner distributions to only those approved by the lender.

Thanks also for the $50M bench mark, it can be something we cane set a target to.

Gary Honig
Title: President
Company: Creative Capital Associates Factoring Co..
LinkedIn Profile
(President, Creative Capital Associates Factoring Company) |

I reached out to one of my bankers, Stefan Hoenicke at Xenith Bank and here is what he offered:

Some general views on covenants:

I try to make covenants easy to understand and easy to measure. EBTIDA, especially on a rolling 12-month basis, and for an S-Corp. is difficult to measure, unless the company prepares quarterly, GAAP based, accrual financial statements. Depreciation and amortization has to be calculated on a quarterly basis. “Deferred” taxes should also be included, an owner of an S-Corp. (or any other “pass-through” entity) may encounter a personal tax liability when his business shrinks and he collects on his A/R. EBITDA is a performance measure and was originally used to measure debt service capacity and cash flow in “highly leveraged” transactions (in the 80s and 90s).

Debt to TNW is a balance sheet ratio to measure “capitalization”, is there sufficient equity in the business? For S-corporations, we use a formula to retain a certain amount of profits in the business after allowing for distributions for tax payments. A company that is too leveraged has more difficulties absorbing any shocks to its business. Growth should be financed with a combination of equity (retained earnings) and debt.

There really is no general level of assets/revenue to determine one or the other measure. Both covenant measure different things and the level is determined by the type of business. If the business has earnings volatility, higher equity is required, stable and predictable earnings allow for a higher leverage. Fixed (valuable) assets can be purchased with a higher portion of debt, investments in business development, business infrastructure, software development etc. need more equity.

Covenants are set to act as “early warning system” and an opportunity to have a discussion of what is going on at a company. They should not be set in stone…

Ben Chang
Title: Director of Finance and Accounting
Company: Transportation & Logistics
(Director of Finance and Accounting, Transportation & Logistics) |

Great insights, thanks Gary.


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