Commentary

Negotiating debt covenants or personal guarantees? Read these tips first

May 22, 2017 by Dustin Minton — National Restaurant Practice Co-Leader, BDO USA, LLP

Editor's note; Vince Stasiulewicz co-authored this blog.

As a restaurant operator in the growing fast casual industry, it's likely you have an existing debt financing agreement, are currently working on debt financing or will seek debt financing in the future. Franchise lenders customarily employ a number of financial covenants as a way to monitor the health and performance of the business. These typically include a cash flow covenant called a fixed charge coverage ratio, and a leverage covenant also known as effective debt to earnings before interest, taxes, depreciation, amortization, and restructuring, or rent costs (EBITDAR).

In addition to the needs of the business, restaurant owners should have an understanding of the economics of their financing arrangements, including all of the verbiage in the loan agreement.

It's important to grasp how covenants are calculated, what revenue and expense items are included and for which entities, how and when the covenants will be measured and how much cushion is built into the covenants at closing. Make sure there is sufficient cushion so any unexpected downturn in business will not result in a failure to meet one of these financial covenants and therefore trigger a default under your loan. Also, keep in mind that these covenants are typically measured on a trailing 12-month basis. So, a problem in one period can continue to cause covenant issues well into the future.

Some notable considerations when negotiating these financial covenants include:

Negotiate the exclusion of new debt proceeds received for the construction of a new store or remodel from covenants until the new location is open or the remodel is complete, as the total EBITDAR will not reflect the EBITDAR expected to be contributed from the new or remodeled store.
Negotiate the definition of what income taxes may be excluded as there are many state taxes that may not be characterized as an income tax but rather as gross receipts or business use tax. Determine whether these other state taxes can be excluded.
Negotiate the definition of non-recurring charges to exclude such items as pre-opening expenses, impairment charges or losses from discontinued operations. Ensure these items are clearly defined in the agreement.
Negotiate the definition of rent to back out the non-cash portion representing the straight-line adjustment and tenant improvement allowance accretion required by GAAP. Rent should be reflective of the cash paid out.

The lender will likely also impose a variety of operating covenants on the business, including limitations on your ability to incur additional indebtedness, grant additional liens, enter into leases or other material contracts, make distributions to owners and more. Think about issues that may arise as you operate your business over the life of the loan, including any required remodel or other capital expenditures, planned acquisitions or expansions, potential buyouts of owners and other issues, and work with the lender to address these issues appropriately in the loan documents.

In addition to operating covenants, understand any personal guarantee requirements for the loan. In many cases, the lender will require a personal guaranty from all "principal" owners of the business, which frequently includes anyone with a 10 percent or greater ownership interest. While the requirement for one or more personal guarantees is generally not negotiable, it may be possible to negotiate with the lender on the maximum amount guaranteed, the length of the guaranty, the requirement for any collateral security for the guaranty and the conditions for full or partial release of the guaranty. This risk can be mitigated through personal guarantee insurance, which may allow the guarantor to insure up to 70 percent of potential liability should the lender require the guarantor to make the debt obligation whole.

Debt negotiations can be difficult and time-consuming. It's wise to consult with professional advisers whom you trust and have franchise finance experience, focusing on key issues that are central to your relationship with the lender. Energy exerted up front to clearly spell out the expectations and variables included in the financial covenant calculation can save significant time and money down the road, and allow you to focus on the growth of the company instead of continually negotiating with the lender to get back in compliance with the debt agreement.

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