A common concern with business loans is covenant compliance. Does my business loan have covenants and if so, what are the compliance requirements? Smaller loans under $100,000 may not require collateral, and are usually free of any covenants, but as businesses grow, so do their financing needs. Business owners looking to borrow over $500,000 can expect the loan agreement to contain some type of covenants or compliance requirements. The covenants typically are either financial, operating, reporting or restrictive in nature. Examples of each are maintaining a minimum cash flow to debt ratio (financial), carrying a minimum level of insurance (operating), submitting financial statements to the lender (reporting), and limiting dividends or payments to shareholders or owners (restrictive).
The covenants are in effect while the loan agreement is in place, and require compliance to be reported to the lender on a quarterly, semi-annual, or annual basis. They provide lenders certain financial and business protections in addition to their rights to the collateral, plus provide information regarding any possible adverse changes in the borrower’s financial condition. In other words, covenants provide an additional security blanket for the lender and serve as an early indicator of possible financial issues on the horizon.
Covenants are written as affirmative actions or negative requirements. Affirmative and negative covenants take on many forms. Affirmative covenants require the company to adhere to certain predefined promises, rules, or regulations. These covenants are written into the loan agreement for the benefit of the lenders, shareholders, and other stakeholders. Examples include requiring the company to maintain certain levels of insurance or paying all taxes on time. Negative covenants restrict a company from engaging in certain activities, such as restricting the payment of dividends to shareholders while the debt is outstanding, or purchasing an unrelated business.
A business owner has to live with the terms of the loan agreement while the loan is outstanding, therefore it is best to determine the company’s future or forecasted ability to comply with the covenants prior to the agreement’s execution. Forward looking projections are important to avoid a potential covenant default and an uncomfortable discussion with the lender at a later date. If a business owner is uncertain as to future compliance with any of the covenants prior to closing, the issue should be discussed and negotiated with the lender beforehand.
Another negotiating topic with the lender surrounding the covenants is the potential for avoiding or removing personal guarantees. Small businesses can have personal guarantees, if present in the agreement, removed after a period of covenant compliance, or avoid personal guarantees with tighter covenants.
If a business finds itself in a covenant violation, the borrow may have a cure period to rectify the violation, if it can be corrected. A cure period for covenant violations will be specified in the loan agreement. Not all covenant violations can be cured or can be cured within the time specified in the loan agreement, so it is best to proactively monitor covenant compliance throughout the year. As is the case with covenants, the ability and time frame to cure defaults can be negotiated into the loan agreement before it is finalized. In the unfortunate instance where a covenant default cannot be avoided, the borrower should notify the lender in accordance with the notice provisions in the loan agreement. The lender may grant a waiver, effectively stating that the lender will not take any actions as a result of the default for a period of time. If the lender does not grant a waiver, their actions can include increasing the interest rates, accelerating the maturity of the loan, or calling the loan to be due immediately.
When entering into loan negotiations with a lender, it is best to obtain advice and assistance from experienced advisers such as a CFO and a good corporate attorney who is experienced in negotiating bank transactions. These professionals will act as a team by adding value in the negotiations, helping everyone understand the various terms and conditions of the agreement, including the covenant provisions, and assist in the loan agreement’s ongoing compliance. Upfront planning, timely compliance, and having the right people and reporting systems in place can avoid covenant compliance issues in the future.
Tom is an Area President for FocusCFO based in Pittsburgh, PA.
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