Recessions are stressful and challenging for any business owner. Even more so when you don’t know if the decisions you’re making are helping or hurting. Every business owner deserves to have a company with a strong financial future.
All recessions have their own unique twist; however, they all follow a pattern. Revenue goes down, there are usually losses, and losses require cash. Before the money runs out, you must decide to pivot your business, which hopefully increases revenue and cash.
During COVID and the Great Recession of 2009, credit became tight, and those revenue losses made an impact on your banking relationship if you borrow money. Remember that commitment letter you signed a long time ago? Well in a period of economic uncertainty, it might be a good idea to pull that letter out and reread it. There are some “red light” words that bankers use that you may not understand. But lack of understanding does not mitigate the banks enforcing their rights if it becomes necessary. Four examples of these red light words are covenant violation, covenant default, demand payment, and forbearance agreement.
If a company loses money during a recession and has a loss at year end, they may have a covenant violation of their cash flow covenant. During COVID, many restaurants experienced substantial losses because of a decline in revenue. While some pivoted and did curbside pickup, it may not have been enough to cover their revenue decline. If they borrowed money from the bank, it’s possible they had a cash flow covenant which promised the bank they would maintain a certain amount of cash flow to pay the bank back. When the cash flow wasn’t enough, they may have experienced a covenant violation. The bank put them on notice that they were in violation, and both parties came together to determine a turnaround plan that was mutually agreeable.
If a mutual agreement can’t be reached, then the bank has a right to declare a covenant default and demand payment on the loan. While the economic circumstances are out of the borrower or the bank’s control, there is legal language that gives the bank the right to declare a default and demand payment. This puts the borrower in a position of paying the bank off at the worst possible time.
Neither the bank nor the borrower wants to see the business liquidated. Generally, that’s a losing proposition for both sides. So, both parties may enter into a forbearance agreement. A forbearance agreement is a legal agreement where the bank will delay or forbear liquidation in exchange for certain concessions. A few examples could be a partial payment of principal, an increase in rate or fees, or additional collateral. Depending on the severity of economic circumstances or economic impact on the business, these circumstances may or may not come into play. But your banker is quite familiar with these terms, and I’ve found many business owners aren’t or don’t fully understand the bank’s rights or their rights in these situations.
In recessionary times of economic uncertainty, knowing these red light words can give you some clarity on what could happen if the economy takes a turn for the worse.
