Frame negotiations and avoid power games by negotiating the facts first.

An oil field pump manufacturer wanted a five-year term loan of several million dollars to double the size of its manufacturing facility and to provide working capital to expand sales to retain market share.  The company’s performance had been uneven – low profit margins, inventory control problems, and other operating inefficiencies – and the addition of  production capacity and the investment in sales (without a guaranty of a return on the investment) might extend or increase  the company’s performance challenges. The company submitted balance sheet and income statement projections with supporting documentation as part of their loan proposal.

While the banker felt the balance sheet was reasonably strong, the bank was concerned about the company’s future revenues and profits. When the CFO and the banker sat down to negotiate loan covenants, the banker’s ‘wants’ included:

• A quick trigger for default  if the company generated losses

• A limit on long term debt/equity limit and a minimum current ratio

• Restrictions on capital expenditures, investment, and dividend payments

• A dollar limit on asset sales in any given year

Where to start the negotiation?

Don’t start with negotiating specific covenants and levels.

“Negotiation” is a process for resolving differences; both parties offer options and trade off concessions in order to reach agreement. Beginning immediately with negotiation of covenants and levels puts both banker and company in the awkward position of gaming the negotiations – the negotiation becomes a game of power and persuasion. One side starts high and concedes toward the middle, the other starts low and does the same. The banker asks for many more covenants that the bank needs, the company asks for three.  The banker asks for highly restrictive limits, the company opens with very loose limits to “give us flexibility.”

Agree on the facts, first.  A better place to start might be to negotiate agreement about the facts – the facts of the company’s performance and how each side interprets them, the facts of conditions in the company’s markets, the facts of the company’s projections and likely variability. Through these discussions, banker and company can negotiate to a set of facts and assumptions on which they agree to agree.

On the basis of that agreement, banker and company can negotiate  covenants and levels.  If both parties have agreed to a fact base and the fundamental objective (i.e. that the company will be able to repay the loan), it’s more likely that the parties will work collaboratively to agree on a combination of covenants that balances the parties’ needs and the levels at which they should be set (e.g.  a $1 million restriction on asset sales vs. $1.5 million) rather than playing power games that can undermine both the negotiation and a relationship.