Bank loans and covenants for MSPs

An MSP borrows for a few predictable reasons: to smooth cash between paying for labor and tools and collecting from clients, to buy hardware for a large project, to fund an acquisition, or to buy out a partner. Bank debt can be cheaper than giving up equity, but it comes with rules. Understanding those rules before you sign matters as much as the interest rate.

Lines of credit and term loans

A line of credit is a revolving facility. You draw what you need, repay it, and draw again, up to a limit. It is meant for working capital, not for long-term investments. Many lines are tied to a borrowing base, usually a percentage of eligible accounts receivable, so the amount available rises and falls with your receivables. Receivables that are too old, owed by related parties or concentrated in one client are often excluded. Some lines also require that the balance be paid down to zero for a period each year.

A term loan is borrowed once and repaid on a fixed schedule over several years. It suits one-time uses such as an acquisition or a partner buyout, where the benefit arrives over time.

MSPs are asset-light. There is little equipment or real estate to pledge, so lenders focus on cash flow and on the quality of recurring revenue. Expect a lien on business assets and, for many smaller businesses, a personal guarantee from the owners. Read the guarantee carefully; it is often the most important document in the package for you personally.

Covenants you are likely to see

Covenants are promises in the loan agreement. Financial covenants require you to keep certain ratios within limits, usually tested quarterly or annually. Common ones include:

• Debt service coverage ratio: cash flow available to pay debt, divided by scheduled principal and interest. It shows how comfortably earnings cover payments.
• Total debt to EBITDA: how many years of earnings it would take to repay all debt.
• Fixed charge coverage: similar to debt service coverage but including other fixed obligations such as leases, and often subtracting taxes, distributions and capital spending.
• Minimum liquidity or net worth: a floor on cash or equity.

There are also non-financial covenants: limits on additional borrowing, restrictions on owner distributions, requirements to keep primary accounts at the bank, and notice obligations for changes in ownership or material lawsuits.

Here is an illustrative example with round numbers. An MSP has $500,000 of annual cash flow available for debt service and $250,000 of scheduled annual principal and interest. Its debt service coverage ratio is $500,000 divided by $250,000, or 2.0 times. Suppose, purely for illustration, the loan agreement requires at least 1.25 times. The minimum cash flow that satisfies the covenant is $250,000 multiplied by 1.25, or $312,500. Cash flow could fall by $187,500, or 37.5 percent, before the covenant is breached. Knowing that cushion, and tracking it each quarter, tells you how much room you have if a large client leaves.

The definitions matter as much as the ratio. How the agreement defines EBITDA, which add-backs are allowed, and whether owner distributions reduce cash flow can change the result. Run your own numbers under the agreement's definitions before you sign, not after the first test date.

The reporting a lender will ask for

Loan agreements spell out what you must deliver and when. Typical requirements:

• Annual financial statements, sometimes prepared or reviewed by a CPA at a specified level of assurance.
• Business tax returns, and personal returns for guarantors.
• Quarterly or monthly internal financial statements.
• A compliance certificate showing the covenant calculations, signed by an owner or officer.
• For a borrowing base line, a periodic borrowing base certificate and an accounts receivable aging.
• Notices of material events, such as losing a major client.

This is where clean monthly books pay off. If your close takes six weeks and your receivables aging does not tie to the ledger, every reporting deadline becomes a scramble, and late or inaccurate reporting can itself be a default.

If you see a covenant problem coming, talk to the lender early. Banks generally have more options, such as a waiver or an amendment, before a breach happens than after.

This guide is general information, not financial, legal or tax advice for your situation. Before taking on debt or signing a guarantee, work with your CPA, attorney and other advisors to review the terms.