What are Common Business Loan Convenants?

In a business loan, the loan covenants are terms you and the lender agree to that must be followed for the life of the loan. If you do not comply with the loan covenants, the lender can call the loan, demand payment in full and declare you in default. So it pays to agree to terms you can meet. Following is an explanation of the goals of loan covenants and common covenants found in business loans.

The Lender’s Goal for Covenants

The lender not only wants to be repaid with interest on the money he has loaned to your business, but he also wants to maintain you as a long-term borrowing customer. Your success is in the lender’s best interest. As a result, the lender’s goals for the covenants are to protect his investment in you and help build your business. These goals include:

  • Keeping high-quality loans on the books;

  • Addressing weakness in your financial statement that need watching but did not disqualify you from borrowing;

  • Helping you protect your equity;

  • Watching your cash flow so the loan can be paid off;

  • Protecting from unforeseeable actions such as death or natural disaster.

Financial Soundness

Common loan covenants will require the business to maintain certain financial ratios at determined levels. These ratios help the borrower and the lender monitor the business’ liquidity, profitability and leverage. The lender will monitor return on assets and debt-to-worth, among other ratios.

Insurance

Other common business loan covenants include requiring the business to insure against a variety of negative situations. Much of what can befall a business and affect its ability to repay loans cannot be predicted, events such as death of key employees, accidents, disasters or legal action. Business insurances exists for all of these and required coverage by loan covenants can include:

  • Key Man Insurance - This insurance pays off if designated key employees die or are permanently disabled.

  • Hazard Insurance - This covers the business if case of accident, natural disaster or other damage to plant or equipment.

  • Business Liability - This covers the business if someone is injured on premise or the business or its employees cause damage.

Significant Changes

It is common for business loan covenants to require that no senior management changes take place without approval from the lender. Often, the business may not take out any other loans without lender approval. The business will not be allowed to make certain capital investments such as new plants or equipment, unless specifically allowed in the loan covenants. In certain circumstances, the lender can require the business to get approval before paying a dividend or before allowing an employee to take cash out of the firm.

Cooperation on Business Information

The lender will expect the business owner to provide all required financial data accurately, completely and at the designated time. Loan covenants will spell out if this is monthly, quarterly or annually, and specify when the lender can inspect the business’ financials and what financial information must be available.