If you think the only way to default on a loan is to miss payments, think again. Loan covenants are a routine component of business financing agreements, and failing to fulfill the obligations they create can result in defaults, too. They can also be the reason you’re able to secure a loan, or the reason you can’t. We’ll walk you through the logistics below.
What Are Loan Covenants?
Loan covenants are legally binding conditions included in business loan agreements that establish requirements your business must meet throughout the loan term, beyond making scheduled payments. For example, your lender may require you to keep a certain amount of cash on hand, submit quarterly financial statements, or obtain approval before taking on additional debt. They help ensure you can pay the debt and, therefore, protect the lender, too.
Types of Loan Covenants and Example Lender Requirements
There are three primary types of loan covenants: affirmative, negative, and financial. Other classifications exist beyond this, but they’re typically tied to how a primary type is measured or customized.
Affirmative (Positive) Loan Covenants
Affirmative loan covenants establish actions your business must take to remain compliant with your loan agreement. These requirements often involve things like maintaining financial transparency, protecting assets, and meeting legal obligations.
For example, your lender may require you to submit quarterly financial statements, maintain insurance on assets pledged as collateral, keep business licenses current, or pay taxes on time.
Negative (Restrictive) Loan Covenants
Negative loan covenants, on the other hand, limit certain business activities or require that you obtain lender approval before making specific decisions. These restrictions are typically tied to actions that could change your business’s financial position or affect the lender’s security.
For instance, your agreement might restrict additional borrowing, limit distributions to owners, or require approval before selling major assets, merging with another company, or taking on significant new financial obligations.
Financial Loan Covenants
Financial loan covenants, sometimes shortened to “financial covenants,” establish measurable financial benchmarks your business must maintain. Lenders typically evaluate compliance using financial statements and ratios that reflect your business’s financial condition.
Common examples include minimum debt service coverage ratios (DSCR), maximum debt-to-equity ratios, minimum liquidity requirements, and minimum net worth thresholds. Your lending agreement will specify how these metrics are calculated and how often they’re evaluated.
Other Types of Loan Agreement Covenants
Loan covenants may also be classified based on how they’re measured, the requirements they address, or how they’re structured.
- Standard Loan Covenants: When a covenant is boilerplate verbiage in a contract or is found in many business loan agreements, it’s considered a “standard loan covenant.”
- Nonstandard Loan Covenants: When requirements are based on your business, financial circumstances, or financing arrangement, they’re considered “nonstandard loan covenants.”
- Quantitative Covenants: If a condition is measured using numerical benchmarks, such as financial ratios or minimum cash balances, it’s a “quantitative covenant.”
- Qualitative Covenants: If a condition is evaluated through actions, business practices, or other nonnumerical criteria, it’s a “qualitative covenant.”
- Nonfinancial Loan Covenants: When requirements involve operational, administrative, or legal obligations rather than financial performance benchmarks, they’re considered “nonfinancial loan covenants” or “nonfinancial covenants.”
Benefits of Covenants in Business Funding
Covenants are an essential component of financial risk management for lenders and funding companies, but they can benefit your business in lots of ways, too.
- Better Financing Terms: Lenders may offer lower interest rates or more favorable terms when covenants help reduce their lending risk.
- Greater Access to Capital: Agreeing to certain conditions may help you qualify for financing that a lender would otherwise consider too risky.
- Improved Financial Oversight: Regular reporting and financial benchmarks can help you identify cash flow problems, rising debt levels, or declining profitability earlier.
- Stronger Financial Discipline: Maintaining agreed financial thresholds can encourage responsible borrowing and help your business preserve resources for future obligations.
Drawbacks of Covenants in Funding Agreement Terms
Although loan covenants can offer financial advantages, they also introduce restrictions and responsibilities that can create challenges for your business.
- Reduced Operational Flexibility: Covenants can create restrictions on borrowing, asset sales, and owner distributions that limit your ability to respond quickly to business opportunities.
- Increased Administrative Costs: When covenants are tied to financial reporting, compliance monitoring, and documentation, it can eat up your time or require you to secure outside accounting support.
- Limited Growth Opportunities: Some covenants may prevent you from pursuing acquisitions, major investments, or expansion plans without lender approval, which can cause you to miss out or stagnate.
- Risk of Breach and Technical Default: Failure to comply with covenants can result in penalties or default on the loan.
- Reduced Financing Options: Existing covenants may limit your ability to obtain additional working capital or use assets as collateral for another financing arrangement.
What is a Covenant Breach?
Lenders typically monitor covenant compliance through financial statements, compliance certificates, and other required reports. Reviews may occur monthly, quarterly, or annually, although some covenants must be followed continuously. Your agreement may also require you to report violations as soon as you become aware of them. When you violate a loan covenant or don’t make good on the requirements, it’s considered a covenant breach.
Actions Lenders May Take in the Event of a Covenant Breach
Your contract will specify what happens in the event of a covenant breach, but it’s often considered a technical default on the loan and can trigger consequences similar to missed payments. However, that’s more of a worst-case scenario. Lenders generally want to recover their money, so they may take several steps depending on the severity of the violation and the terms of your agreement.
- Allow for a Cure Period: For more minor covenant breaches, such as failing to provide documentation, some loan agreements provide a cure period, or a window of time to make things right.
- Grant a Waiver: More than 60 percent of covenant violations are waived without changes to major loan terms, per the Journal of Accounting Research. This effectively means that the business doesn’t face major consequences. Lenders are more likely to grant waivers when they believe a situation is temporary. For instance, if the business fails to meet the minimum debt service coverage ratio or liquidity requirements but will likely be able to do so soon, a waiver may be granted. However, sometimes waivers come with additional requirements or penalty fees.
- Modify Loan Terms: Lenders may be contractually allowed to increase your interest rate, introduce stricter covenants, or renegotiate repayment terms.
- Restrict Funding: Sometimes lenders will reduce your available credit or suspend additional borrowing.
- Accelerate Repayment: A lender may also declare the outstanding loan balance immediately due if an event of default permits acceleration under your agreement.
How to Negotiate Loan Covenants Before Signing
Loan covenants are often negotiable, particularly when your business has a strong financial history or you’re considering offers from multiple lenders. Negotiating before signing gives you the opportunity to establish reasonable requirements that protect your access to funding and accommodate your business’s future needs.
Key Loan Covenant Negotiation Strategies
Consider having a business attorney and financial advisor review the proposed agreement before signing. They can help identify restrictive provisions, clarify potential consequences, and negotiate terms that support your long-term business plans.
During negotiations, focus on the provisions most likely to affect your cash flow, business operations, and plans for growth.
- Review Financial Projections: Compare proposed financial thresholds against your current performance and future projections. Account for seasonal fluctuations or slower periods to ensure you have enough breathing room.
- Negotiate Financial Ratios: Request realistic thresholds for requirements such as debt service coverage, liquidity, and debt-to-equity ratios. Clarify how each ratio is calculated and when it’s tested.
- Protect Future Borrowing Options: Negotiate exceptions or limits that permit additional financing, including equipment loans, lines of credit, or other working capital arrangements.
- Address Operational Restrictions: Request reasonable exceptions for activities your business may need to undertake, such as purchasing equipment, selling assets, or making distributions to owners.
- Establish Cure Periods: Seek reasonable opportunities to correct certain violations before they become events of default.
- Compare Lender Offers: Evaluate covenant restrictions alongside interest rates, fees, and repayment terms. You may find that the offer with the lowest interest rate isn’t ideal if it comes with covenants that significantly restrict your business.
What to Do When Loan Covenants Restrict Additional Funding
Existing loan covenants can complicate your efforts to secure additional business funding, particularly if your agreement restricts new debt or gives your lender a claim to business assets. However, these restrictions don’t necessarily prevent you from accessing more capital.
Explore Your Additional Funding Options
Start by reviewing your loan agreement to identify the specific restrictions involved. You may have several ways to move forward without violating your existing terms.
- Check for Permitted Borrowing: Some agreements allow additional financing up to certain limits or for specific purposes, such as equipment purchases.
- Request Lender Consent: Your lender may approve additional funding if you can demonstrate that it will strengthen your business without jeopardizing repayment.
- Negotiate a Covenant Amendment: If existing restrictions are too limiting, ask your lender to modify them to accommodate your funding needs.
- Explore Invoice Factoring: Factoring converts unpaid customer invoices into immediate working capital. Because it’s generally structured as a sale of receivables rather than a traditional loan, it may provide another funding option. However, existing covenants or liens can still restrict factoring.
- Request a Subordination Agreement: If your current lender has a lien on your accounts receivable, it may agree to subordinate its interest or release specified receivables so you can work with a factoring company.
Find Out Your Invoice Factoring Terms
Generally speaking, it’s better to apply for factoring before you’re tied up with covenants or liens because your lender may be unwilling to negotiate after the fact. Moreover, factoring provides immediate working capital based on the value of your invoices and can scale with your growth, often providing enough capital without the need for loans and allowing your business to avoid adding debt to its balance sheet. But even if you already have covenants and require additional capital, you may still be a candidate if your lender is willing to renegotiate. To explore your options, request a no-obligation rate quote.
DISCLAIMER: This article is not intended to provide finance, insurance, or legal advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, finance, insurance, or legal advice. You should consult your own finance, insurance, or legal advisors before engaging in any transaction.
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