Companies often seek funding sources to get off the ground and expand their outreach. It’s a typical aspect of most businesses’ quest for optimal success. This is especially true for startups and SMEs, where financial challenges impede their maturation.
It’s only reasonable for such entities to leverage the multitude of funding options to support their growth goals. And it’s no surprise that debt financing is a practical financing model preferred by most entrepreneurs. Still, it’s not easy to acquire loan financing from most lenders.
The stringent criteria, documentation, requirements, and lengthy applications deployed by lending firms have seen many firms fail to qualify for loans. Loan covenants are some of the restrictions deployed by financiers to limit borrowers’ actions. Unfortunately, it doesn’t get better. Loan covenants can be hard to crack and a significant setback to your funding objective.
On the other hand, it’s paramount to have a solid grasp of how they operate and the potential consequences of a loan covenant breach. This post elucidates more on loan covenants: what they are & what it means for your startup.
What are loan covenants?
Loan covenants are agreements between borrowers and lenders that the party acquiring the debt will work within specific rules set by the moneylender. It’s a contract that stipulates the terms and conditions of loan policies between the involved parties.
Loan or debt covenants offer lenders the freedom of providing loans while still protecting their lending position. In addition, borrowers can understand their financier’s expectations.
Note that loan covenants don’t necessarily favor lenders, or they don’t intend to burden the borrower. Instead, they express the interests of the moneylender by forbidding specific actions by the borrower that could result in adverse effects or loss for the lender—for example, defaulting the loan.
Similarly, they benefit the borrower by minimizing the cost of borrowing. When a borrower plays along with the imposed restrictions, it’s only reasonable for the lender to charge low-interest expenses and fees.
Essentially, there are three types of debt covenants:
- Positive loan covenant
- Negative loan covenant
- Financial loan covenant.
Here is a detailed explanation of each and its meaning for your startup.
Positive loan covenants
Positive or affirmative loan covenants remind borrowers that they should perform certain activities to ensure optimal financial performance. They guide the borrower on what’s expected of them. The most elementary examples of affirmative loan covenants include tax compliance and maintaining positive cash flow.
Other common positive loan covenants include:
- Lenders expect your startup to maintain credible and verifiable bookkeeping. As a result, banks, venture capitalists, and other financiers can seamlessly establish your startup’s health every financial year.
- Excellent and accurate record-keeping to help monitor your business health.
- Maintain relevant insurance policies for the business and extend them to financiers as additional insured parties.
- For a starting point, maintain certain levels of some financial ratios. Banks recommend keeping favorable debt to equity ratios, debt to asset ratios, and networking capital.
- Perform regular maintenance of capital assets.
- Lenders expect your startup to comply with your locale’s respective laws and licenses.
Negative loan covenants
Negative or restrictive loan covenants create boundaries around financial and ownership matters made by the borrower. These covenants state what borrowers can’t do in favor of the lender. The most prevalent and typical loan covenant requires your startup to avoid seeking finances from other lenders. Other examples of negative loan covenants include:
- Prevention of acquisition or mergers without the primary lender’s consent. Borrowers must seek permission to take specific actions to alter a firm’s capital structure.
- Limits the selling of assets and equipment without the lender’s approval. Similarly, borrowers cannot invest without the lender’s consent.
- Your startup cannot distribute dividends over a certain amount or without your financier’s permission. The same also applies to stock practices like distributing and paying shareholders.
In sum, restrictive loan covenants streamline your startup’s credibility and minimize the chance of defaulting.
Financial loan covenants
Finally, financial loan covenants measure how well your startup is performing against the projections issued by the lender. As you can expect, financiers tend to be pleased if you almost hit the targets or achieve better results. On the other hand, if there is no progress on hitting the set financial projects, the higher chance you might default on the loan.
Some typical financial loan covenants include the current ratio and borrowing base calculation. Essentially, financial loan covenants restrict the amount of credit your startup can access from its line of credit.
What if your startup breaches the loan covenant?
It’s important to monitor whether or not your startup is complying with the debt covenants, especially with current and projected financial statements. Outsourcing or hiring a financial controller will go a long way in ensuring compliance and that you are on top of your finances. And importantly, ensuring you do not breach any of the loan covenants.
A breach of loan covenants could be detrimental to your startup’s health. Predominantly, it depends on the severity of the violation. For instance, most lenders can create waivers to accommodate minor infringements, such as extending deadlines if you forget to submit your financial statements promptly.
On the other hand, extreme violation of loan covenants such as obtaining other financiers without your lender’s consent could cause the lender to suspend your loan, stop additional funding, demand early payments, or seize assets you provided as collateral. Additionally, your lender has the right to launch legal action. Ultimately, you might have to part with hefty interests and fines to cover the costs incurred by your financier as a result of the breach.
Proper and constant communication between the borrower and the lender can help resolve breaches quickly and amicably. But, most importantly, it can help ensure your startup doesn’t violate the loan covenant in the first place.
Final thoughts
Understanding loan covenants is crucial for all businesses. Of course, it’s best to always liaise with a certified financial professional before negotiating for a loan and before any significant changes in your startup that may impact the debt covenant. Indeed, you can always arrange for more favorable terms and conditions for your loan with financiers. Still, well-established ventures are better positioned to bargain loan covenants. As a result, it would be best to consider these alternative lending options to charge your startup for success.
