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What Is a Loan Covenant?

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Last editedMay 20212 min read

As a small business, applying for a loan can be a hugely beneficial tool to facilitate growth. If you’re confident in the ability of your business to grow and succeed, and you just need a bit of extra financial support to get things moving, a loan is the perfect solution.

In order to ensure the terms of your loan are clear, you should always request the negotiation of loan covenants.

Loan covenants explained

When a loan is made, a contract between the borrower and lender may be signed to verify all of the terms and conditions surrounding the agreement. These contracts are known as loan covenants. Loan covenants protect both the lender and the borrower and ensure complete transparency over what each party is able to do.

There are two main types of loan covenant – affirmative loan covenants and negative loan covenants.

Affirmative loan covenants

Affirmative loan covenants outline the various actions that the borrower is expected to perform to reach certain financial targets. It might include actions like ensuring tax obligations are managed promptly, ensuring bookkeeping is maintained accurately and on time, and ensuring the business abides by state and federal laws.

Affirmative loan covenants ensure that the borrower is making the most of their financial support in a sensible, productive way. Essentially, affirmative loan covenants detail the ‘must-dos’ for a borrower in order for a loan to be valid.

Failure to comply with affirmative loan covenants typically result in default of the loan.

Negative loan covenants

On the other hand, negative loan covenants outline the ‘must not-dos’.

Negative loan covenants can include actions like altering the organizational or capital structure of the business without notifying the lender, making investments without the lender’s permission, agreeing to mergers without transparency and approval of the process, and selling or writing-off assets.

Lenders want to ensure they’re clear on what their financial support is going towards – and negative loan covenants make this possible.

Financial loan covenants

Another type of loan covenant is a financial loan covenant. These loan covenants detail any restrictions put in place on the amount of credit a borrower can access in a given period. The lender may include conditions that state the borrower can only borrow certain amounts if certain targets are reached, providing a threshold based on the financial targets outlined prior to the agreement.  

Loan covenant compliance

A borrower is expected to abide by the policies stated in the loan covenant, and failure to do so can result in major consequences.

The covenant in loan agreement contracts might also outline the dispute resolution process and what steps must be taken if a loan covenant is breached by either party. The actions surrounding a breach are defined by the lender and can vary in severity.

Some lenders may offer an extension if certain information, like financial statements, aren’t submitted on time – issuing strict warnings before turning to harsher penalties. The lender might insist that any disputes are handled with out-of-court settlements. They could offer debt buybacks to make it easier for borrowers to pay back debt in smaller instalments.

However, some lenders might have far stricter terms. A lender can liquidate the borrower’s collateral in the case of default, or might force a business to claim insolvency should the business no longer be feasible.

Negotiating loan covenants

Both parties must agree to the policies outlined in the loan covenant, and as a small business, you have the right to negotiate the terms and conditions included. Lenders want a strong, stable, and trustful relationship with their borrowers – and they want to ensure their financial support will help you succeed. Therefore, lenders should be happy to negotiate the terms of the loan covenant to ensure they benefit every party and facilitate your growth.

In order to ensure you’ve got negotiating power, you need to be able to present a detailed business plan to potential lenders, along with financial statements and projections that prove your viability. Covenants are used by lenders to limit the risk of lending, but if you’re able to exhibit healthy financial growth, good credit, and a well-thought out, actionable business plan, you can convince the lender that the risks aren’t all too high, and in turn, negotiate less stringent terms.

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