What Are Loan Covenants?
A covenant is simply a fancy term for the word ‘promise’. Banks include covenants in their loan agreements to preserve their position as the lender and to improve the likelihood a loan will be paid back by the business owner/borrower on time, in full, and in accordance with the loan’s terms and conditions.
Loan Covenants spell out exactly what the business owner agrees to do with respect to the business’ capital structure during the term of the loan or business line of credit. These promises made by business owners can vary and most loan documents have some, but not necessarily all of the loan covenant examples defined in this post.
Knowing what to expect when you apply for bank financing and ultimately sign a lender’s loan document will help a business owner be well-prepared before and during the term of the loan.
Types of Loan Covenants
Bank loan agreements may include three types of loan covenants. These include: Affirmative Loan Covenants, Negative Loan Covenants, and Financial Loan Covenants.
Affirmative Loan Covenants
An affirmative loan covenant is used to remind the borrower they should be doing certain activities to maintain the financial health and well-being of the business.
- Requirement to pay all business and employment-related taxes
- Requirement to maintain current financial records and to deliver to the lender for review certain types of reports such as a Certified Public Accountant’s Compiled, Reviewed or Audited financial statement each year.
- Requirement to maintain adequate insurance policies for the business and possibly include the lender as a separately named ‘additional insured’ party
- Requirement to maintain the business entity in good standing with the state where it is formed
Negative Loan Covenants
A negative loan covenant is used to create boundaries for the company and its owners. Such boundaries are usually related to financial and ownership matters.
Lenders may include negative loan covenants which require the business owner to seek the bank’s permission to take certain actions as such actions may change the business’ capital structure. Such requirements to obtain the lender’s permission may seem as if the business owner must ask “Mother, may I?…” and often are not evident to the business owner until many months, or even years, after the loan has been obtained.
- Limiting the total amount of indebtedness for the business and/or shareholders
- Restriction on or forbidding distributions and/or dividends paid to shareholders
- Restriction on or forbidding management fees paid to related parties
- Prevention of a merger or acquisition without the lender’s permission
- Prevention of investment in capital equipment, real estate, or other businesses without the lender’s permission
- Prevention of the sale of assets without the lender’s permission
- Maintenance of a specific or targeted Debt Service Coverage Ratio
Financial Covenants in Loan Agreements
Financial loan covenants are used to measure how closely the business performs against the financial projections provided by the business owner, CFO, or management. Certain financial loan covenants may be used to restrict the amount of credit the business can access from its line of credit.
Financial Covenants Examples Include:
- Current Ratio (Current Assets divided by Current Liabilities
- Borrowing Base Calculation where a defined maximum percentage is applied against the business’ eligible Accounts Receivable to determine how high a Line of Credit may be drawn.
Breach of Loan Covenants
In the event the business owner violates one or more of the loan covenants, the lender may dole out a number of consequences as it sees fit. Depending on the offense, your lender may simply voluntarily create a waiver to accommodate the issue. For example, if you forget to submit your financial statements on time, they may simply extend the deadline.
However, in the event of a more serious violation (like taking out another loan without your lender’s permission), your lender may have the right to suspend its loan, demand early repayment, seize the assets you pledged as collateral, halt any additional lending to you, or initiate legal action.
And in most cases, lenders will charge additional fees to cover their additional costs when a loan covenant has been broken by the borrower. These fees can be very costly. These breach of contract fees are defined in the loan or line of credit agreement in the fine print.
Business owners should note that even an unintentional violation of a loan covenant may become a serious matter. Some banks automatically turn their business accounts in violation of a bank covenant over to the Workout or Special Assets Group for resolution. Should this happen, a business owner may be forced to find an alternative source of business capital to grow their business.
Are Bank Loan Covenants Negotiable?
Absolutely yes! Loan covenants are negotiable between the bank and the business owner when the bank or lender offers a borrower a loan and defines its proposed terms in the form of a Letter of Interest.
Although a lender’s Letter of Interest or credit facility proposal is not binding on the part of the lender, it does serve as a good place for a business owner to begin to understand how the lender intends to impose loan covenants on the business owner. It’s always best to understand loan covenants before agreeing to accept a lender’s business loan.
Latest posts by Holly Magister, CPA, CFP
- How to Pay Yourself as a Business Owner - November 6, 2019
- How to Overcome Customer Concentration Objection When Selling a Business - May 22, 2019
- Understanding the Business Buyer Types When Selling Your Business - April 12, 2019