A minimum tangible net worth covenant requires the borrower's equity, after subtracting goodwill and other intangible assets, to stay above a floor set in the loan agreement. Lenders use it to make sure there is a real cushion of hard assets beneath the debt. On an operating company it usually works as intended. On an acquisition it often does not: the price paid above the value of the hard assets becomes goodwill, so the new company can start with negative tangible net worth. An acquisition loan needs the covenant replaced, reset or built to step up from the closing figure.
- Formula
- Total equity − goodwill − other intangibles (plus lender-specific deductions)
- What it tests
- The cushion of hard-asset equity beneath the debt
- Usually tested
- At fiscal year-end, sometimes quarterly, from the balance sheet
- What erodes it
- Losses, distributions, loans to owners, write-offs
- Acquisition problem
- Goodwill from the purchase can leave it negative at closing
How tangible net worth is calculated
Net worth is the equity line of the balance sheet: total assets minus total liabilities. Tangible net worth strips out the assets a lender cannot sell in a liquidation, on the view that equity backed only by goodwill is not equity a lender can rely on.
| Line | Treatment | Why lenders do it |
|---|---|---|
| Total stockholders' or members' equity | Starting point | Book equity from the balance sheet |
| Goodwill | Subtract | Exists only as long as the business is a going concern |
| Customer lists, trade names, non-competes, other acquired intangibles | Subtract | Hard to sell separately from the business |
| Loans and receivables due from owners or affiliates | Often subtract | Money that left the company and may not come back |
| Capitalized financing costs, organization costs | Often subtract | Accounting assets with no resale value |
| Subordinated debt, such as a standby seller note | Sometimes add back | Owed, but ranked behind the lender, so it cushions the lender like equity |
The deduction for amounts due from owners is the one owners most often overlook. A business that runs personal expenses through a shareholder receivable, or lends cash to a related real-estate entity, can pass the covenant on a plain reading of the balance sheet and fail it on the bank's.
Why acquisition borrowers start below zero
When a buyer pays more for a business than the book value of its hard assets, the accounting records the difference as goodwill and identified intangibles. In a typical lower-middle-market acquisition, most of the price is for earnings, not equipment and receivables, so most of the price becomes goodwill. See financing a purchase that is mostly goodwill.
Take a purchase price of 10,000 for a company with net tangible assets of 3,000. The buyer funds it with 1,500 of equity and 8,500 of debt.
| Balance sheet at closing | Amount |
|---|---|
| Net tangible assets acquired (receivables, inventory, equipment, less payables) | 3,000 |
| Goodwill and intangibles recorded | 7,000 |
| Debt | 8,500 |
| Book equity (the buyer's contribution) | 1,500 |
| Tangible net worth (1,500 − 7,000) | −5,500 |
Nothing is wrong with this company. It runs exactly as it did the day before closing; only its capital structure has changed. But a covenant written for an operating company, a minimum tangible net worth of some positive figure, is breached from the first test. A bank that pastes its standard covenant into an acquisition loan has written a default into the agreement.
Where the goodwill lands depends on the deal. In an asset purchase, it sits on the buyer's books. In a stock purchase, it may sit at a holding company rather than the operating company, depending on how the purchase is accounted for, so a covenant tested at the operating company may never see it. Which entity is tested, and on what basis, is worth settling before closing; see borrowing at the holding company vs the operating company and purchase price allocation.
How tangible net worth moves after closing
Tangible net worth grows when the company earns money and keeps it. It shrinks with losses, distributions and anything the definition deducts. Amortization of acquired intangibles, where the company books it, reduces both equity and the intangibles being subtracted by the same amount, so it leaves tangible net worth unchanged. What moves the number is retained cash earnings.
- Distributions reduce it one for one. A company that distributes all its earnings for owner taxes and income never builds tangible net worth, which is why the covenant is often paired with a limit on restricted payments.
- Loans to owners reduce it if the definition deducts affiliate receivables.
- Write-offs of bad receivables or obsolete inventory reduce it in the year they are booked.
- Repaying a subordinated note reduces effective tangible net worth where the note was being added back.
The question a tangible net worth covenant really asks is whether the owners are leaving earnings in the business.
Negotiating it: acquisition versus operating-company refinance
The covenant serves a lender differently in the two situations, so it should be written differently.
| Operating-company refinance | Acquisition | |
|---|---|---|
| Starting position | Usually positive, built up over years | Often negative, because of purchase goodwill |
| What the lender wants to know | That equity is not being drained | That the new owner is rebuilding a cushion |
| Workable forms | A fixed floor set below today's figure with room for a bad year | A floor starting at the closing figure and stepping up by part of each year's net income; or net worth rather than tangible; or no balance-sheet test at all |
| Usual companions | Debt service or fixed charge coverage | Leverage and fixed charge coverage, which measure what an acquisition lender actually relies on |
| Watch for | Affiliate receivables, planned distributions, one-off write-offs | Which entity is tested, whether subordinated seller debt is added back, the size of each annual step |
On an acquisition the best outcome is often to drop the test and rely on cash-flow covenants: the fixed charge coverage ratio and the total leverage ratio. Private credit funds that lend on cash flow rarely ask for tangible net worth at all. Banks are more attached to it, and where they insist, the step-up form works: the covenant measures improvement from where the company actually starts, instead of an absolute level it cannot reach for years.
On a refinance of an established business, the covenant is usually harmless if the floor leaves room. Model it against your plans before you agree to a figure: a planned distribution, a buyout of a partner or an inventory write-down can each take it through the floor in a year when the business is performing well. See covenant headroom for how much room to ask for.
If you are close to the floor
A tangible net worth breach is usually a balance-sheet event, not a cash-flow crisis, and lenders tend to treat it that way if they hear about it early. The usual remedies are an owner contribution of equity, converting shareholder loans into equity, subordinating owner debt so it can be added back, or an amendment that resets the floor. See what to do when you breach a loan covenant. An agreement with an equity cure may already say how a contribution counts.
Transparent's financing model projects every covenant in the term sheet, balance-sheet tests included, from the closing balance sheet forward, so a covenant that cannot be met is caught while it can still be rewritten.
Common questions
- What is the difference between net worth and tangible net worth?
- Net worth is total equity on the balance sheet. Tangible net worth subtracts goodwill and other intangible assets, and often amounts owed by owners and affiliates, leaving the equity backed by assets a lender could sell.
- Can tangible net worth be negative?
- Yes, and after an acquisition it often is, because most of the purchase price is recorded as goodwill. That reflects the accounting of the purchase, not a weak business.
- What is effective tangible net worth?
- Tangible net worth plus debt that is subordinated to the lender, such as a seller note or shareholder loan on standby. Lenders that use it treat subordinated debt as part of the cushion beneath their loan.
- What is a debt to tangible net worth ratio?
- Total liabilities divided by tangible net worth: a balance-sheet measure of leverage that some banks test alongside, or instead of, a minimum. It stops working once tangible net worth is negative, which is another reason it rarely suits an acquisition loan.
- How do distributions affect the covenant?
- Every distribution reduces equity, and so tangible net worth, one for one. A business that distributes all of its earnings will not grow its tangible net worth even in good years.