Business owners who apply for a loan to help facilitate business growth must read the loan covenants carefully before agreeing with the lender. What are loan covenants? Loan covenants are the terms and conditions of a loan between the borrower and the lender.

These terms and conditions protect both parties and ensure transparency throughout the loan period. Borrowers who need to practice good Loan Covenant Compliance strategies risk incurring penalties and a loss of reputation, which can close the doors to accessing future loan opportunities.

Types of Loan Covenants:

Loan covenants are drawn around two main types: affirmative loan covenants and negative loan covenants. It makes sense to understand more about these two types of covenants.

Affirmative Covenants: Affirmative covenants are the actions borrowers must perform to reach financial targets. For example, one common affirmative covenant is tax obligations, where the borrower promises the lender to manage any tax obligations promptly and accurately. 

Additionally, another common covenant drawn between borrowers and lenders is that they will operate under the abiding state and federal laws. The primary function of affirmative covenants is to ensure that borrowers use the funds they receive sensibly and productively. 

Negative Loan Covenants: Just like affirmative covenants are actions that borrowers promise to carry out, negative loan covenants are the opposite of affirmative covenants. In an affirmative loan covenant, borrowers promise to carry out specific actions under the loan agreement. In a negative covenant, the reverse happens, where the borrower promises not to undertake particular activities stipulated in the loan agreement. Common examples of negative covenants include altering organizational or capital structure without notifying the lender. Another common type of negative covenant is one where the borrower agrees not to make any investments without securing the lender’s permission first. Negative covenants ensure that lenders have a certain amount of control over the investment of the funds they give to the borrower.

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Consequences of Failing to Comply with Loan Covenants

Failing to comply with the loan covenant terms can have significant consequences for borrowers. It can hurt a borrower’s reputation, which leads to a loss of customers and can prevent the borrower from applying for future loans. If a borrower defaults on loan repayments, a lender might liquidate the borrower’s collateral to recoup the payment. Sometimes, the business might be forced to claim insolvency if it fails to repay its loans. For this reason, borrowers should aim to negotiate suitable loan covenant terms to help them create a flexible and customized approach that suits all parties involved.

Loan Covenant Compliance Tips

Here are some tips that can help borrowers manage loan covenant compliance in better ways:

Create an Extensive Summary of The Covenants: A summary document helps borrowers keep track of the various loan covenants they must comply with. This document should include relevant dates, reporting periods, and other specific definitions requiring monitoring.

Keep Calendar Reminders: A business must share many reports and processes with the lender under its loan covenant agreement, meaning several team members must meet the deadline to comply with the lender’s terms. Keeping calendar reminders for all relevant team members is a great way to draw attention to a compliance report.

Build a Financial Covenant Forecasting Model: Forecasting where the company needs to meet required covenants is a great way to ensure you are on track. Carefully review the loan agreements to ensure you know all the financial variables necessary for accurate calculations.

CONCLUSION

Businesses that want good loan covenant terms should approach lenders who are flexible and willing to negotiate good terms. Doing so gives businesses a chance to create customized repayment options and have some say in the affirmative and negative covenants that are drawn up. Following sound strategies for effective loan covenant compliance is a good way for borrowers to protect their credit scores and secure future funding.