Business Loan Covenants

For the prospective business borrower, the first time they hear about loan covenants is when they talk to their lender or read some reference to them in the documentation that the lender provided. Covenant is a fancy word for condition, and they are a form of protection that the lender adds to the loan for the lenders benefit.

What do covenants protect from?

Covenants protect the lender from an adverse change to the borrower. Good commercial underwriting looks at the historical performance, and tries to estimate the likely performance of the borrowing entity in the future. However, reality has a way of ruining the nicest looking forecasts, and that is why covenants are useful.

Do financial covenants really matter anyway? By the time the borrower violates the covenant, it will be too late.

Not really, the covenants need to be drafted in a manner that they serve their purpose and allow time for the lender to perform a protective action. You want the covenant to be triggered while the company as a going concern shows signs of stress, but it is otherwise viable.

What are the most common financial covenants?

Financial covenants can be divided into two categories {Performance and Condition}.

Performance covenants deal with the ability of the borrowing entity to repay the debt. Keeping an eye on this ability can be accomplished by taking the cash flow of the company and comparing it to the debt burden {the sum of all the principal and interest due}. The resulting ratio is known as the “Debt Service Coverage”.

Condition covenants deal with the capital structure of the borrower and can center on the relationship of debt to equity or in the case of larger firms the relationship between debt and cash flow.

What is a protective action?

A protective action is what the lender would do if a covenant is not met. One has to remember that failing to meet a covenant is an event of default, which gives the lender the leverage to ask for concessions in order to waive the non-compliance. Examples of protective actions are:

-       Line of credit freezes.

-       Changes in advance rates.

-       Additional collateral.

Can a covenant create a structural weakness?

Bad Loan Covenants create structural weaknesses in a loan. In order for covenants to be useful, they need to make sense. If the strength of a deal is the great levels of equity of a borrower, setting up the covenant so low as to allow that capital structure to deteriorate completely would be an example of a useless covenant.

Is there anything else that covenants can control?

The list can be endless, but covenants are commonly used to prohibit the borrower from doing the following:

  • Incur and guarantee additional indebtedness
  • Create liens on assets
  • Sell capital stock of subsidiaries
  • Make investments
  • Pay dividends in amounts anticipated or at all
  • Make capital expenditures
  • Change ownership or structure, including engaging in mergers,  consolidations, Liquidations or dissolutions
  • Enter into a new line of business
  • Change the management Sell, transfer, assign or convey assets.
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