Is A Debt Covenant A Dealbreaker? What Covenants Are & Why They’re Required For Small Business Loans
Whether you’ve already launched your small business or are still in the early planning phases, you might be exploring different funding options to get off the ground, expand, or weather tough times. There are many options for funding a small business, and it can be challenging to know where to start.
When internal capital isn’t enough to cover costs, many small businesses take out loans. Before diving in and taking on debt, it’s helpful to familiarize yourself with some of the more complicated terms and lingo you’ll encounter when searching for small business loans.
A debt covenant is one such term you will likely come across. Let’s take an in-depth look at what debt covenants mean for a small business loan, why they’re used, and how to determine if their conditions are a fit for your needs.
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What Is A Debt Covenant?
Debt covenants come in various forms, but they can be broadly characterized as a set of restrictions or agreements between a borrower and a lending institution or creditor. They may also be referred to as banking covenants, financial covenants, and loan covenants.
The terms of a debt covenant are disclosed before a loan is granted. Typically, borrowers must abide by the covenant’s terms until the loan is repaid. If the borrower violates these conditions, the lender may have the authority to impose penalties, terminate the loan, or intervene in some other capacity.
Why Lenders Use Debt Covenants
When financial institutions, creditors, or any lender grant a loan, they are doing so based on an evaluation of the borrower’s ability to pay the loan back with interest. Therefore, it should come as no surprise that lenders aim to minimize the risk of borrowers defaulting on their loans.
Covenants are one tool at a lender’s disposal to better ensure that a borrower operates their businesses in a way that will increase the likelihood of repaying the loan on time. First, these agreements establish clear terms, such as expectations and permitted financial behavior, with the intention of getting all parties involved on the same page. Additionally, covenants usually outline measures that the lender can take if the agreed-upon terms are violated. Some examples include the following:
- Charging penalties or fees
- Increasing the loan’s interest rate
- Increasing the total collateral
- Terminating the loan entirely
Altogether, these measures are a way for the lender to reduce risk and recuperate losses in the event that a borrower fails to repay a loan.
How Covenants Work
The details of a covenant will depend on the lending institution and the financial status of the small business seeking a loan. But essentially, a debt covenant can be thought of as the rules and conditions the borrower must follow and fulfill until the loan is repaid.
Many aspects of covenants coincide with the successful financial and legal operation of a business, including a positive growth rate and compliance with tax law. Some more complex debt covenant criteria you may encounter include:
- Debt-to-Equity Ratio: Using the formula (Total Liabilities / Total Shareholders’ Equity), this metric shows to what extent a small business is financing itself with debt compared to its own funds.
- Debt Service Coverage Ratio: This measures a business’s cash flow, and is calculated by dividing net operating income by the current year’s debt obligations.
- Total Assets: This includes the total value of cash, land, equipment, and inventory that a small business possesses.
A covenant may set a specific threshold for any of these criteria that a business must stay above or below.
Typically, there will be some grace period to correct and remedy a violation, and more understanding lenders may be willing to enter into a discussion or negotiate with borrowers on how they’ll move forward with the agreement. If a violation does result in a penalty, there will likely be successive stages of enforcement, beginning with small fees before escalating to the termination of a loan.
Types Of Covenants
Covenants can be sorted into two distinct categories: positive and negative. The key difference is that positive covenants are things that borrowers must do, whereas negative covenants represent what you cannot do during a loan’s lifetime.
Largely known as positive covenants, you may also see these referred to as affirmative covenants. Here are some examples of positive covenants in the context of a small business:
- Maintaining satisfactory financial ratios, such as profit ratio, debt-to-equity ratio, and debt service coverage ratio.
- Keeping a specified minimum amount of cash.
- Providing accurate financial statements on time and according to schedule.
- Providing life insurance for designated employees
These types of covenants are designed to prohibit behavior that could pose a potential risk to the success of the borrower’s small business and loan repayment. Some possible examples include the following:
- Selling critical assets like land or buildings to make loan payments.
- Changing ownership or merging with another business.
- Taking on a large recurring expenditure, such as a lease agreement.
- Taking out additional loans or debt.
How Common Are Debt Covenants?
The likelihood of a debt covenant depends on the amount of money borrowed, the timeframe for repayment, and a small business’s financial background. Emerging small businesses in particular should expect to take on debt covenants to secure a loan with favorable terms.
Is A Debt Covenant A Dealbreaker?
Generally speaking, a debt covenant isn’t cause for alarm on its own. Deciding whether a loan is right for you depends on how restrictive the covenants are and the potential risk of violating their conditions.
It’s important to think through and understand the various scenarios in which your business might breach a covenant and consider the potential risk associated with each. If you believe you and your small business are prepared, then by all means, proceed. However, it’s worth comparing lenders to find terms that align with your needs.
In some cases, a debt covenant may actually pose benefits for borrowers. For instance, accepting debt covenants may help a borrower negotiate a lower interest rate or reduce associated fees since the lender has more assurances that the loan will be repaid. Additionally, these covenants may help small business owners better monitor their financial wellbeing and make improvements and adjustments accordingly.
Debt Covenants: The Bottom Line
Debt covenants cover a wide range of financial, legal, and operational agreements between a lender and borrower. Though they come with some caveats, debt covenants can help get your business on track and assist you in acquiring funding. Having a clear understanding of your small business’s current debt and finances can help determine whether a debt covenant is beneficial and feasible for you.