Owner Dependence in a Middle Market Credit
When a founder holds the customers, the know-how and the decisions, a lender is really underwriting one person. How to structure a loan around that fact.
Who, exactly, is the business? I ask myself that before I ask anything about margins, and for most large borrowers the answer is dull: a set of contracts, a brand, a workforce, systems that run whether or not any particular executive shows up on Monday. For many middle market companies the honest answer is a name. The founder knows every major customer personally, sets the prices in his head, approves every purchase above a trivial amount, and carries the relationships with the suppliers who extend terms. If that is the answer, then the loan I am being asked to make is secured, in the ways that count, by one person. Everything else in the file follows from admitting it.
Questions I put to an owner dependent file
How would I know the owner is the business?
The signs are rarely stated. They show up in the org chart, where every line runs to one box. They show up in the customer list, where the largest accounts have been with the company exactly as long as the founder has. They show up in the management conversation, when a question about pricing or a key supplier is answered by the owner even when it was addressed to someone else. And they show up in the absence of documents. A company that runs on one person’s judgment often has no written pricing policy, no formal credit approval for customers, and no second signer on the bank accounts.
Why does it matter if the business is healthy?
Because the cash flow I am lending against is partly a return on the owner’s personal effort, and personal effort is not a durable asset. It can end suddenly through illness or death. It can erode slowly through fatigue, distraction or a change in priorities. It can be withdrawn deliberately if the owner decides to sell, retire or start something else. None of those events is a default under an ordinary loan agreement, yet each can impair the credit as surely as a lost customer.
Can I simply avoid these companies?
A lender who refuses every owner dependent borrower will not lend much in the middle market. Dependence is the normal condition of a company at this size, not a defect peculiar to a few. The better course is to price it, measure it and build the structure around it.
What does measuring it look like?
Take a hypothetical industrial distributor. I would ask three things. How many of the top customers have a working relationship with someone other than the owner? If the owner were gone for a quarter, who would set prices and approve credit, and have they ever done so? And what share of the company’s institutional knowledge is written down, in the form of procedures, customer histories and supplier terms, rather than carried in memory? The answers do not produce a score. They produce a picture of how far the value would fall if the owner stepped away, and how quickly.
How does the structure account for it?
Several tools help, and they work best together.
Key person life and disability insurance, assigned to the lender, converts the sudden version of the risk into cash. It does nothing for the slow version, but it removes the worst tail.
A personal guarantee, full or limited, ties the owner’s own balance sheet to the outcome. It is less about recovery than about alignment. An owner with personal exposure behaves differently when the business weakens.
A change of management clause, making the departure or incapacity of named individuals an event the lender must be told about and can act on, ensures the lender is at the table when the risk becomes real rather than learning of it from a delayed report.
Conservative sizing matters more than any of these. A loan sized to the cash flow that would survive the owner’s absence, rather than to the cash flow the owner currently produces, leaves room for the business to find its footing under someone new.
What about the next generation, or the named successor?
A successor on paper is not a successor. I want to see the person in the management conversation, answering questions without deferring. I want to know which customers they already handle and which suppliers know their name. A second in command who has run the business for a stretch while the owner stepped back is worth far more than a promising relative who has not yet been tested. Where the intent is to hire an outside executive later, that plan belongs in the structure, with milestones the lender can see.
Does owner dependence ever help a credit?
It can. A committed owner with capital at stake often manages cash more carefully than a hired team, cuts costs faster in a downturn, and picks up the phone when the lender calls. The same concentration that creates the risk creates a counterparty who cares intensely about the outcome. The job is to capture that commitment without being exposed to its disappearance.
What do I watch after the loan closes?
Signs of withdrawal. An owner who starts talking about a sale, spending less time on site, or delegating in a hurry is changing the credit. Monthly reporting shows the numbers, but the conversation with the owner shows the direction, and I weigh the second as carefully as the first.
Lending to an owner dependent company means betting on a person’s next several years.
So what is the covenant that matters most?
It is the one no agreement spells out. Every owner dependent credit carries an unwritten promise that the owner will build a business able to run without him before he stops running it. No ratio tests it and no certificate reports it, yet its breach is how many sound middle market loans go bad. When I underwrite one of these companies, I am really underwriting whether that promise will be kept, and the most useful thing the structure can do is make keeping it cheaper for the owner than breaking it.