Business Loan Covenants — What’s in Your Documents?

Loan covenants are requirements and/or restrictions that a lender imposes as part of a business loan agreement. With credit still tight and the economy still sluggish, lenders are very serious about loan covenants. You should be, too.

Covenants fall into three categories:

Affirmative covenants are requirements that your business must fulfill. Some examples include submitting periodic financial statements to the lender, carrying certain types of insurance policies, and making current employment-tax payments.

Negative covenants are restrictions that prevent you from doing certain things without the lender's approval. Some examples of things that might need to be preapproved include borrowing from other sources, making management changes, and selling equipment.

Financial covenants require your business to maintain various financial ratios related to working capital, net worth, profitability, and cash flow.

Finances in the Spotlight

How do lenders know if you're in compliance? They review your financial statements, tax filings, and other reports. Depending on the terms of your loan agreement, your lender may even conduct on-site field audits every now and again to verify that you have the assets that are serving as collateral for your loan.

The Cost of Noncompliance

If you violate a covenant, your loan will technically be in default, putting your lender in a position to either take the collateral securing the loan, call the loan, or require that the terms of your agreement be substantially modified. You may have an opportunity to "fix" the problem before the lender takes action against you -- or you may not.

Be Careful

Anytime you apply for a new loan, be sure to carefully review the covenants that may be included in your agreement. Some terms may be negotiable. Then, just as carefully, evaluate whether your company will be able to comply.