Ten considerations for owners of closely held companies incurring new debt in connection with minority investments by private equity sponsors, financing future growth, and dividend recapitalizations.

1. It’s all about the “leverage.” The company’s ability to service the new debt by making required principal and interest payments is of paramount concern to everyone involved. Financial covenants, such as Total Leverage Ratio and Fixed Charge Coverage Ratio, will test this periodically (typically on a quarterly basis). As evidenced by low default rates throughout the loan markets, lenders and private equity sponsors are keenly focused on ensuring that their investments are appropriately leveraged for projected financial performance. Relatively conservative leverage may of course limit the size of debt-financed dividends or distributions, but will certainly help to ensure future company value.

2. Future dividends and distributions. The loan documents will restrict future dividends and distributions by the company. Significant dividends and distributions are often prohibited (other than for purposes of making required tax payments in the case of a company that is a flow through entity such as an LLC or an S-corp). Since the new debt is frequently incurred to finance a significant liquidity event for equity holders, or the incurrence of the new debt helps set the table for company growth resulting in a significant future liquidity event, concerns over restrictions on dividends and distributions during the term of the loans are mitigated, but should not be ignored. Consider adding dollar baskets, tests based on excess cash flow (after giving effect to mandatory debt reductions) and “leverage based” tests to loan documents to allow for the payment of future dividends and distributions on at least a limited basis.

3. Financing your company. You’re probably used to financing your company through equity investments and shareholder loans. Lenders in lower middle market transactions will often require that the proceeds of equity investments in your company, for purposes other than capital expenditures and permitted acquisitions, be applied to repay their loans. Additionally, lenders will restrict the amount of other debt (including subordinated debt) that the company may incur. With this in mind, having an appropriately sized working capital or “revolving” credit facility in place with the new lenders is an important consideration. Lenders are often willing to agree to committed “delayed draw” facilities to finance planned future acquisitions and/or uncommitted “accordion” facilities for the same purpose. You may also have the ability to negotiate carve-outs for shareholder loans to the company, but keep in mind that the terms of these loans, including applicable interest rates, will need to be arms-length.

4. Financial reporting. Depending on your company’s current financial reporting procedures, your new loan documents may require more detailed and burdensome reporting than you are used to. In addition to the annual audit, unaudited monthly and quarterly balance sheets, income statements and statements of cash flows, together with quarterly MD&A, are to be expected. Financials will also be required to be prepared in accordance with GAAP, or in some cases, IFRS. It is not uncommon for lenders to provide slightly more time than usual for the fiscal periods ending immediately after the closing to produce required financial reporting. This is intended to help the company adjust to new reporting requirements.

5. Future acquisitions and other investments. Much like dividends and distributions to equity holders, actions of the company not in the ordinary course of business, such as acquiring other businesses and making other investments (including investments in joint ventures), will be restricted by the loan documents. Consider adding dollar baskets, tests based on excess cash flow (after giving effect to mandatory debt reductions) and “leverage based” tests to loan documents to allow for the consummation of acquisitions and other investments on at least a limited basis. Future acquisitions by the company must also be of entities in the same or substantially the same businesses.

6. Change of control. The loan documents will include provisions that prohibit the sale of more than a majority of the voting (and often economic) rights in the company to a person other than certain equity holders at closing. In connection with a minority investment by a private equity sponsor in a company that remains majority owned by its founders, the founders and the sponsor should be careful to make sure that the founders have the right in the future to sell their equity interests to the sponsor without triggering any change of control default in the loan documents, thereby requiring lender consent to such transaction. Furthermore, the loan documents should allow for the founders to transfer their equity interests in the company to their designated trusts, successors and other estate planning vehicles, without the consent of the lenders.

7. Equity co-investments. Many lower middle market lenders want the ability to co-invest in the same equity securities of the company that the equity holders (including the private equity sponsor) have invested in at closing. The size of such equity co-invest varies, but is typically a de minimis amount of the aggregate equity capitalization of more mature companies. This is of course a way for lenders to ride the upside of a company they are excited to partner with and boost their returns on the investment.

8. Board observation rights. Some lenders, such as those governed by Venture Capital Operating Company regulations or lenders that are Small Business Investment Companies, will require the right to attend company board meetings (and sometimes committee meetings) so long as any, or a significant portion, of their loans remain outstanding. These are commonly referred to as “board observer” rights, are for informational purposes only (as opposed to actual voting rights) and are typically subject to exceptions for conflicts of interest among the company and the lenders.

9. Equity cure rights. Even if a breach of a financial covenant (such as the Total Leverage Ratio or Fixed Charge Coverage Ratio) has occurred, remember that not all is necessarily lost and otherwise dependent on the lenders granting a waiver of such breach and charging a fee or asking for other accommodations in connection with such waiver. In many loan documents for lower middle market transactions, the equity investors are permitted to retroactively cure financial covenant defaults by making capital contributions (and sometimes subordinated loans) to the company in an amount equal to the EBITDA necessary to put the company into compliance with such financial covenant. Keep in mind, however, that the proceeds of the cure are often required to repay the loans and that special adjustments may need to be made to the equity documents of the company to allow for one equity holder to make contributions for such purposes without the consent of the other equity holders. Note that while equity cure rights are commonly contained in loan documents, they are rarely implemented.

10. Trust your partners and counsel. Remember that your co-investors, lenders and legal counsel all want the company to succeed. Such success is in everyone’s best interests. Relying on the market knowledge and guidance that investment professionals and outside counsel provide in connection with the negotiation of your debt financing not only allows you to devote more time to what’s most important to you (including running your business), but should also provide you with valuable peace of mind during the financing process and in the future as your company continues to grow.