Partner draws, guaranteed payments and the coverage ratio

A law firm, an engineering practice or an accounting firm hands over a tax return showing 100,000 of net income and is told the loan does not cover. The firm generated 1,250,000 of cash before partner compensation that year. Both statements describe the same business. The gap between them is the single most important conversation in professional-services lending, and most owners walk into it unprepared.

The firm asks for 600,000 over seven years. At an illustrative 9 per cent, the payment is 9,653 a month and annual debt service is 115,841.

• Coverage on book net income: 100,000 divided by 115,841 is 0.86. Declined.
• Coverage after adding back partner compensation in excess of a market replacement salary — say 220,000 each, so 660,000 of market salary and a 490,000 addback: 590,000 divided by 115,841 is 5.09. Approved comfortably.

Nothing about the firm changed. One number was reclassified.

Why the addback is not automatic

The lender's question is honest: if the partners stopped taking 1,150,000 and took only what the market would pay someone to do their work, would the firm still produce enough cash to service the debt? That is a real test, and it fails for plenty of firms.

The tension is that in a professional partnership, the partners are the revenue. A market replacement salary for a rainmaking senior partner is not a line in a salary survey, because the replacement does not bring the clients. The lender knows this. What they will usually accept is a defensible replacement cost for the production work, not the ownership return — and the gap between the two is where the negotiation happens.

Three things decide how much addback you get:

The addback list, in the order underwriters accept it

1. Interest on debt being refinanced. Uncontroversial.
2. Depreciation and amortisation. Uncontroversial, though a firm with real equipment replacement needs should not pretend the cash requirement is zero.
3. One-time items. A litigation settlement, a move, a failed lateral hire. Document them; an underwriter has seen every recurring expense described as one-time.
4. Owner compensation above market. The big one, discussed above.
5. Discretionary personal expenses run through the firm. Vehicles, travel, family on payroll. These get added back only when they are documented well enough to be believed, and raising them has a cost — see what happens if I run personal expenses through the business. A firm that produces a long list here is telling the lender the books are not a reliable record.
6. Rent paid to a related entity above market. Added back to the extent it exceeds market, and only with an appraisal or a comparable.

Present these as a schedule, with a source document behind each line, reconciled to the tax return. Not as a conversation.

What the coverage ratio is calculated on

Ask which of these the lender means before you compute anything, because the answers differ by a wide margin:

• Global coverage, including the partners' personal debt service and living costs, which is common where personal guarantees carry the deal
• Firm-only coverage on adjusted cash flow
• Coverage on a trailing twelve months, on the last full tax year, or on an average of two or three years
• Whether the proposed new debt is the only debt counted, or all existing obligations including capital leases and the partners' notes

Global coverage is the version that catches professional firms out. Three partners with large mortgages, tuition and their own draws being restricted by a standby can produce a global ratio well below the firm-only figure. The mechanics are set out in debt service coverage ratio, step by step.

The collateral problem behind all of this

A professional firm has receivables, unbilled work, furniture and a lease. On liquidation, the receivables collect at a discount because the clients are already moving elsewhere, the unbilled work is worth close to nothing because nobody will bill it, and the furniture is furniture. This is why coverage carries the entire decision and why the personal guarantee is not negotiable in practice.

It also means the partner-compensation argument is not a technicality you can lose and still get funded on collateral. It is the deal.

What to have ready

• Three years of firm tax returns and the current year to date, with a reconciliation between the tax return and the internal profit and loss
• A partner compensation schedule by individual, split between guaranteed payments, draws, distributions and benefits
• A written market-salary support for each partner's production role — a published survey figure, a comparable employed-professional salary in your market, or a written offer one of your senior non-equity staff has received
• The partnership or operating agreement, with the compensation and admission provisions flagged
• An ageing of receivables and unbilled work in progress, with realisation history: what percentage of recorded time is actually billed, and what percentage of billed is actually collected
• Personal financial statements for every partner who will guarantee

What to ask for, and what to refuse

Ask the lender, before you submit, which addbacks they will accept in principle and what evidence they want for owner compensation. Ask whether the ratio is firm-only or global. Ask what happens to the addback if a partner leaves during the term — some agreements contain a covenant that treats a partner departure as a material adverse change, which converts an ordinary retirement into a default.

Refuse a covenant that caps total partner compensation at a fixed dollar figure without an escalator tied to revenue. A firm that grows 30 per cent and cannot pay its partners more has a covenant that punishes success. Ask instead for the cap to be expressed as a minimum coverage ratio to be maintained, which lets the draws rise with the cash flow that supports them.