If you are about to ask for a business loan, expect to deal with the issue of covenants — constraints lenders impose on your company to keep it operating within specified financial ratios and to prevent it from taking certain actions.
These clauses are meant to help the lender mitigate risk and get its money back. But if you are not careful, they can put your company in a stranglehold. Under some very strict loan agreements, if your firm violates a covenant, it can automatically go into default and be forced to pay the loan in full immediately. Typical commercial-loan covenants can require your business to, among other things:
When considering a loan, you want to try to at least loosen, if not eliminate, the obligations that will be most difficult for your business to meet. Try to negotiate covenants that leave you the flexibility to run your business prudently. Some loan requirements set sound benchmark metrics that can help keep your company healthy. Others, however, could be too difficult to meet and result in disastrous consequences.
Here are four important considerations before you officially ask for — or agree to — a commercial loan:
For example, if you have a monthly fixed-rate loan, the bank could argue that your company's financial controls should make such notice unnecessary. You, on the other hand, could maintain that missed deadlines can sometimes result from computer malfunctions or business trips where executives with check-signing authority are out of town. This type of discussion could be sparked by each default provision. Some give and take is required to reach a compromise. For instance, you and your lender might agree to a limit on the number of late payment notices allowed before your business is in default. The goal is to make it easier for your company to avoid default while assuring the lender there are adequate mechanisms in place to protect its interests.
Although you have to expect to agree to certain covenants when you take out a commercial loan, get guidance from your accountant as well as your attorney on how to effectively negotiate fair and reasonable terms that you don't inadvertently violate. It could accelerate a premature demand for repayment and cause financial hardship for your company.
When talking to lenders, make sure your enterprise's financial projections include a full financial model of income statement, balance sheet and statement of cash flows on a monthly basis. This will reflect any seasonal fluctuations in the business plan.
Develop early warning mechanisms to alert management if your company reaches a point where it may violate a covenant. Have a checklist of steps to monitor compliance with all provisions of the loan agreement.
Reassure your lenders that you are on top of the terms your company accepted. Explain the plan of action your business will take if it breaches any obligations. Lenders want to know that your organization's management is taking steps to protect their collateral and to ensure that the loan is repaid.
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