When small businesses make application for a bank loan or a bank term loan, and are approved, the loan agreement often contains loan or restrictive covenants. A restrictive loan covenant is simply a statement in the loan agreement between the lender and borrower (in this case, the small business) stating that the small business can and cannot do certain things while it is paying on the bank loan.
Companies that banks consider higher risk will have more restrictive covenants. Companies that banks consider to be lower risk will have fewer restrictive covenants. Risk is determined on a number of factors by the bank including creditworthiness, financial statements, cash flow, collateral, business insurance, and your business plan. Other factors may also be used to determined restrictive covenants.
Affirmative or Positive Loan Covenants
Affirmative covenants are things that the small business or borrower must do while it is repaying its business loan. Examples of affirmative or positive covenants are very basic - meet financial obligations, pay taxes, and maintain a positive cash flow. Other possible affirmative covenants are to maintain business insurance, maintain your collateral, and accurate recordkeeping.
The bank may also ask the small business to maintain certain levels of particular financial ratios. Examples of financial ratios that banks may watch are the debt to equity ratio, the debt to asset ratio, and the company's net working capital.
Restrictive or Negative Loan Covenants
Negative loan covenants limit the borrower's behavior in favor of the bank. In other words, the small business borrowing the money has to refrain from taking specific actions. The most common negative covenant requires the company not to borrow any money from any other lender.
Negotiating Loan Covenants with your Bank
The stronger your company is financially, the better position you are in to negotiate loan covenants with your bank. Banks use loan covenants to protect their interests and limit their risk. They would not make a loan to your small business, however, if they did not want your business to succeed. So there is room for negotiation. You will need to present the bank with a well-developed business plan, complete with financial statements, in order to negotiate covenants with the bank.
Monitoring Loan Covenants and Dealing with Covenant Breaches
The small business owner must constantly monitor whether or not the company is complying with the covenants of the loan, preferably with current and projected financial statements. It is best if your CPA helps you with this task as not every small business owner is a financial expert.
One of the CPA's most important functions is to be sure the small business does not breach any of the loan covenants. Sometimes, a breach of a covenant is unavoidable. For example, what happens if the debt to asset ratio goes above the level set by that particular loan covenant? The short answer is that it depends on the severity of the breach. The penalty imposed by the bank can range from a letter in the file of the small business to the bank calling in the loan. Other middle range penalties might include a rise in the interest rate charged on the loan or some sort of one-time financial penalty.