SMB Business Loan Covenants: What You Need to Know
Small business borrowers should always completely read their loan documentation before signing it. During my bank lending career, I have made many hundreds of loans and can’t remember any of those borrowers reading their loan documents. Now that I am a consultant representing business owners acquiring loans, I make sure they read their documents and completely understand each specific loan covenant.
Some business owners are surprised when they discover several quarters after signing loan documents that they are in default of their loan because they failed to comply with one or more loan covenants. A wise borrower knows what covenants will be expected before they ever get to loan closing. Even smarter is to ask about covenants at the early stages so they can be negotiated where applicable.
Why do banks have loan covenants? Simply put, banks want to protect their loan and the collateral for the loan. In order to do this, they want to know that management is going to run the business in a professional manner and protect the bank’s interests in the process.
The lender wants to make sure the business has an adequate liquidity position so it can pay all obligations in a timely manner, including its loan payment to the bank. The bank wants to make sure the company maintains profitability so it can have the resources (profits) to easily operate and grow. Lastly the bank wants management to take steps to protect its collateral and insure that if there is a catastrophe of some sort, the company can still repay the loan.
Typical affirmative loan covenants:
- Borrower agrees to maintain various kinds of hazard insurance like property and general liability.
- Borrower agrees to maintain “key man” life insurance on certain management.
- All taxes (especially 941) and state fees must be paid and kept current.
- Quarterly or monthly financial statement submission to the bank.
- Accounts payable and accounts receivable report submission to bank monthly.
- All shareholder loans to business must be subordinate to the bank’s loan.
- On large loans, a bank may require that the annual financial statement be a “reviewed” or “audited” financial statement.
- Borrower agrees to maintain liquidity and performance ratios.
- Submission of annual corporate tax return
- Submission of annual personal tax return of personal guarantors.
Often used negative loan covenants (borrower prohibitions):
- No changes in management or merger without lender’s permission.
- No distribution of profits without prior lender approval.
- No further loans from other sources to company without lender approval.
- No increase on owner’s annual draw or distribution without prior lender approval.
- No sale of equipment without prior lender approval.
Loan covenant problems are fairly common with fast growing companies because key financial ratios are sometimes difficult to maintain. Liquidity and performance ratios are often difficult to maintain for a fast growing company.
Don’t get sloppy on forgetting the simple covenants like submitting financials and tax returns on time. If you do foresee a problem with a covenant, prepare a realistic plan for getting your company in compliance and discuss it with your banker as soon as practical. Most importantly, keep track of your key financial ratios on a monthly basis so you know your business is healthy and in a position to thrive.
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