TnC Is Not Just a Cable Channel: Loan Tips for Nonprofits

I’ve been lending to nonprofit organizations for close to 20 years. Most organizations take on debt responsibly, but I’ve also seen some nonprofits with loans that are more harmful than helpful.

For instance, I helped one organization that houses special needs individuals realize that they have a negative amortization loan. This means that at the end of the loan term the bank would have owned the property and the residents would have to leave.

I actually don’t blame the nonprofit for this entirely. The executive director started the program when she was in her twenties and didn’t have the financial training required to grow an organization. That said, she wasn’t totally innocent. The organization should have had a board member or attorney review the loan documents to prevent such a possible calamity. The bank that underwrote the loan was also at fault.

There are several issues most bankers would like any nonprofit to consider before taking out a loan. Most of these restrictions are described in what is commonly referred to as, Ts and Cs, or terms and conditions. I’ll spell out the key points below, but please note these are not exhaustive. I always suggest having an attorney or board member with relevant experience go over loan requests.

One of the biggest items to consider when taking out a loan is the timeframe. Make sure the term fits the purpose of the loan. For instance, if you think your construction project is going to last 18 months, then make sure your loan has a two-year time frame. That way if/when the construction timetable slips, you won’t need to scramble at month 17.

Many financial institutions will also outline financial and social covenants. That’s fine, but just make sure they are based on your historic performance. Don’t set yourself up for failure.

Typically, a lending institution will require liquidity, leverage, and profitability covenants. Liquidity requirements are usually some form of current ratio (current assets/current liabilities). Basically, they want to see that you have enough cash to pay your bills. This makes sense and requires you to focus on your operating cash.

Leverage covenants focus on how much debt your organization has compared to your net assets, in most cases, your unrestricted net assets. The issue being addressed is how much debt you are taking on to pay for assets. The bank may also limit the amount of debt you can take on in the future. So be aware of that restriction, especially if you may be expanding in the coming years.

Profitability covenants focus on whether your organization is in the black or red. Of course, with temporarily restricted funding and cost accounting, this gets a little confusing. So make it clear whether the covenant is for the program the lender is funding or for the organization overall. Ask how they want to deal with multiyear grants and temporarily restricted funds. Call out any questions up front to limit problems later on. Likely the covenant will require a certain level of net income and may have a debt coverage ratio.

Make sure that you understand what these ratios are and how they’re derived. For instance, can restricted cash be included in your current account? Confirm the definitions of these ratios with your lender and ask questions where there’s ambiguity.

Now, if you’re borrowing from a foundation, social investor, or impact investor, they will most likely require social covenants as well. Social covenants are very similar to grant outcomes; however, they’re specifically spelled out in loan documents. If you fail to meet them, your loan could be in default. So be clear about what you can actually accomplish and when. Don’t fall into the trap of thinking you’ll be able to scale at the pace the foundation proposes. Be reasonable and give your organization a little leeway.

Another big red flag I will share is around the frequency and amount of reporting. Some lenders may require quarterly reporting. If you don’t produce quarterly statements, don’t agree to this. Push back a bit and suggest every six months.

The last point is to ensure that the number of social and financial covenants is reasonable. I worked with one foundation that required 25 social covenants, ten financial covenants, and a narrative every quarter. It’s important that lenders understand your concerns and limitations. It should be possible to figure out a happy medium as they want to see you succeed.

If you have questions about how to structure a loan, feel free to send me an email at mrand@americannonprofits.org.