When your small business applies for a bank loan, and it’s approved, the loan agreement will likely contain loan or restrictive covenants. It’s simply a statement between lender and borrower stating that your small business can and can’t do certain things while you’re paying on the loan.

If the bank considers your business high risk, you’ll likely have more restrictive covenants. Lower risk companies will have fewer. Banks determine risk on several factors, such as:

  • Business insurance
  • Creditworthiness
  • Collateral
  • Cash flow
  • Business plan
  • Financial statements

What You Need to Know About A Negative Loan Covenant

Sometimes, lenders choose to create a firewall around major ownership and financial decisions made by you, the small business owner. To do this, they ensure they own the rights to notifications such as alterations of capital structure.

In turn, this streamlines your credibility and lowers your chances of defaulting. That’s why it’s important for you to make sure you understand the terms of the loan covenants to ensure you aren’t caught up in any unintentional cross-fires as lenders will do what they can to hang on to their investment.

Some of the most common negative loan covenants include:

  • No changes in management
  • No mergers without the lender’s permission
  • Profits may not be distributed without the lender’s approval
  • You may not seek other loans from other sources without lender approval
  • The business may not sell equipment without lender approval
  • You may not increase on your annual draw or distribution without prior consent

What You Need to Know About An Affirmative Loan Covenant

Contrary to negative loan covenants, affirmative covenants remind borrowers that they must perform certain activities to maintain healthy business operations. In turn, this creates a stable financial return.

Should you breach this covenant, you’ll be in default of your obligations and the lender may impose a grace period in which to fix the violations. The worst case is that the lender may announce it as a default and demand full repayment.

Common affirmative loan covenants include:

  • You agree to maintain hazard insurances such as general and property liability
  • Your company must submit regular financial statements to the bank
  • You agree to maintain “key man” life insurance on management
  • The business must submit accounts receivable and payable reports monthly
  • You must submit annual corporate tax returns
  • All state fees and taxes to be paid and kept up to date
  • You must submit annual personal tax returns of personal guarantors
  • All shareholder loans must be subordinate to the bank loan
  • On larger loans, the bank may require a review or audit of the annual financial statements
  • You agree to maintain performance and liquidity ratios

Covenants Can Protect Your Small Business

Provided you have a thorough understanding of loan covenants, they can protect your business. On the whole, covenants protect your earning assets.

Loan covenants either require you do something or prohibit you from doing something. Another two common types of loan covenants are quantitative and qualitative.

With a quantitative loan covenant, you may have to keep up a particular debt-to-worth ratio as set out by the bank. Alternatively, you may not exceed a certain debt-to-worth ratio. Also, with this type of covenant, you may be required to maintain a certain ratio of cash to total assets.

With a qualitative loan covenant, you may have to provide financial statements within 10 days of the close of every quarter. Or, you may not incur any further debt from other lenders without the bank’s prior agreement.

Loan covenants ensure you don’t sell off your equipment, for example, that you need to provide your service or make your products. Covenants are aimed at keeping you out of trouble and your business afloat.

Negotiating Loan Covenants with Your Lender

The financially stronger your small business is, the better the position you’re in to negotiate your bank’s loan covenants. Banks use the loan covenants to limit risks and protect their interests. They’re not going to make a loan to a small business if they don’t want you to succeed, which means there’s almost always room for negotiation.

You’ll need complete financial statements and a well-thought-out business plan if you want to negotiate. But, you’ll also need a thorough understanding of loan covenants, which is why it pays to have a knowledgeable lawyer on side.

Book a consultation at Principal Law Firm today for assistance with your loan covenants and negotiations.

 

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