Why Lenders Include Covenants in a Loan
Lending money to a business is an investment in its future success. To protect that investment, lenders use covenants as financial guardrails. These rules help ensure your company remains stable and capable of repaying the debt as agreed. They are a standard feature in most commercial lending, from small SBA loans to large corporate credit lines.
The Two Main Types of Loan Covenants
Covenants generally fall into two categories: rules about what you must do and rules about what you cannot do without permission.
Positive Covenants (What You Must Do)
Also known as affirmative covenants, these require you to take specific actions that demonstrate financial health and transparency. Common examples include:
- Provide Financial Statements: Submitting regular reports (quarterly or annually), such as income statements and balance sheets.
- Maintain Financial Ratios: Keeping key metrics above a certain threshold. A common one is the Debt-Service Coverage Ratio (DSCR), which shows if you have enough cash flow to cover debt payments. A lender might require your DSCR to stay at or above 1.25x.
- Pay Taxes and Insurance: Staying current on all tax obligations and maintaining adequate business insurance.
- Maintain Key Person Insurance: If your business relies heavily on one or two individuals, the lender may require a life insurance policy on them.
Negative Covenants (What You Must Not Do)
These restrictive covenants prohibit you from taking certain actions without the lender’s prior consent. Their purpose is to prevent you from making risky moves that could jeopardize repayment.
- Taking on More Debt: Prohibiting new loans above a certain amount without approval.
- Selling Key Assets: Forbidding the sale of major assets, especially those pledged as collateral.
- Limiting Major Purchases: Restricting capital expenditures (large purchases of equipment or facilities) over a specified amount.
- Changing Ownership: Preventing the sale of the business or significant changes in its ownership structure.
- Paying Dividends: Limiting how much profit can be distributed to owners, which keeps cash in the business to service the debt.
What Happens If You Violate a Covenant?
Breaking a covenant, even by accident, results in a technical default. This is different from missing a payment—you could be current on every payment but still be in default if your DSCR falls too low. A technical default gives the lender legal grounds to take action. Consequences range from penalty fees to acceleration, where the lender demands immediate repayment of the entire outstanding loan balance.
How to Manage and Negotiate Loan Covenants
Covenants are a serious part of your loan, but they are manageable if you approach them strategically.
- Read the Fine Print: Before signing, review every covenant with your accountant or a lawyer to ensure you fully understand your obligations.
- Negotiate Before Signing: Some terms may be negotiable. If a restriction is too tight for your business’s growth plans, ask the lender if they are willing to adjust it.
- Track Everything: Create a compliance calendar to track due dates for financial statements and schedule regular reviews of your key financial ratios.
- Communicate Proactively: If you think you might break a covenant, inform your lender immediately. They are more likely to offer a temporary waiver or solution if you are transparent and have a plan to get back on track.
Frequently Asked Questions (FAQs)
Are loan covenants negotiable?
Sometimes. While many covenants are standard, lenders may negotiate certain terms based on the borrower’s creditworthiness and relationship. It never hurts to ask before you sign the agreement.
Do all small business loans have covenants?
Most traditional bank loans and government-backed loans, like those from the U.S. Small Business Administration (SBA), include covenants. Simpler financial products like business credit cards may have fewer formal covenants but often come with higher interest rates.
What is the difference between a technical default and a payment default?
A payment default occurs when you miss a scheduled loan payment. A technical default happens when you violate a non-payment rule (a covenant) in your loan agreement. Both are serious and can trigger adverse action from the lender.