If you borrow money, you may expect that the terms of the loan, including the loan amount, payment terms, interest rate and all other terms, are listed in the cover letter. The rest of the documents may look like inaccessible lawyer filler that have no bearing on your conduct.  But, in fact, that is wrong.

Most people simply don’t read the loan documents they are about to sign.

Intro to Loan Covenants. Business bank contracts usually have these paragraphs called “loan covenants.” These are minimum standards and prohibitions for you and your business to meet.  Loan covenants are the bank’s weapon against bad management or economic downtimes. The bank uses the loan covenants to pressure the borrower into keeping enough cash flowing to pay its debts, to keep growing and to protect the bank’s investment and collateral.

The Stakes. What happens if you violate one of these covenants? The bank can call your loan and make you repay it today. The bank may also be able to increase your interest rate. If you can’t repay the loan, the bank could move to grab the collateral you have pledged to the bank to sell it. In other words, all bad things.

TIPS FOR LOAN COVENANTS
  1. Read and understand every page and every clause before you sign.
  2. Don’t be afraid to negotiate any clause you don’t thing is fair.  That includes financial ratios.
  3. Once you sign, make sure you get at least one folder of all documents.
  4. Give copies of your financial covenants to your accounting professional to make sure you stay vigilant on compliance.  (Particularly beware of the positive cash flow covenant.)
    And, if you have to produce audited financials, reserve plenty of cash and time for the audit fees.
  5. Calendar the due dates for delivery of financial statements or other reports.
  6. If you have to sign a personal guaranty, negotiate limits and terminations so if you leave or get deposit, the guaranty ends.

Loan Covenants can be “affirmative” covenants to do something and “negative” covenants to refrain from doing something.

Affirmative Covenants
These are typical do’s:

  • Get and keep liability and property insurance with minimum coverage amounts
  • Get and keep “key man’ life insurance on top management
  • Pay all taxes and state fees on time
  • Deliver certificates of insurance to the bank
  • All loans must be subordinate to the bank’s loan
  • Financial statements must be prepared and “reviewed” or “audited” each year, and then delivered to the bank. Push back on audit requirements if you can.
  • Maintain liquidity and performance ratios
  • Deliver annual corporate tax returns

Negative Covenants
These are typical don’ts:

  • Change management
  • Merge with another business
  • Take other loans
  • Issue dividends
  • Increase management salaries
  • Sale of assets

3 Comments

  • January 9, 2012 Reply

    Timmy

    Do these covenants also come with an Ark?

  • January 12, 2012 Reply

    5 altace buy mg

    Great Post!

  • April 16, 2012 Reply

    Business Law

    your points are really valid. people are normally found not negotiating when signing the loan agreement and hesitate to ask if they found their selves unable to understand any of the clauses written on the agreement.

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