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Understanding Business Loan Covenants

Business Loan Covenants are more complex than many business owners believe. If you ask most people, they will tell you that loan agreements are fairly simple. The bank agrees to advance a certain sum of money and the borrower agrees to repay the loan with interest over a certain amount of time. If it were that simple, however, loan documents would be two sentences long not dozens of pages. It is a mistake to think the “boilerplate” provisions of a loan agreement are unimportant. In reality, the boilerplate language is as important in these documents as is the stated principal and interest. And “boilerplate” is a very inaccurate description of the legalese in the contract, as it is often possible to negotiate these terms.

Loan covenants, especially in the context of business loans, can be very complicated and can trigger a default by the borrower without the borrower being aware of the problem. Covenants, as the name implies, are merely promises by the borrower to do certain things, or to refrain from doing certain things, while the debt is owed. We have had more than one new client come to us and tell us that the bank has declared a default and has demanded payment in full on their loan. The client then tells us that the bank “can’t do this” because not a single payment has been missed. Unfortunately, the covenant to make payments when due is but one of many covenants in most commercial loan agreements.

Reviewing loan covenants and fully understanding their meaning serves three functions. The borrower can often negotiate the change or elimination of covenants to loosen the restrictions under the contract and reduce the risk of default. Secondly, the borrower, if it understands the covenants, can tailor its behavior to minimize the probability of default; often the events leading to default could have been altered if the borrower properly understood the consequences of its decisions. Lastly, if the covenants are overly restrictive and cannot be negotiated, the borrower can decide to forego the loan. While borrowing money to fund business growth is often a wise decision, if a default under the loan agreement is likely, and a default will bring about the death of the business, it may be a wiser decision to find an alternate way to fund the growth…or to put the plans for growth on hold.

So, what are these covenants? They could literally be just about anything the bank wants to put in the agreement. Financial Covenants based on net income or net worth are not uncommon. With these covenants, the borrower agrees that it will be in default if it does not produce a specified amount of net income for any given year during the term of the loan (or some adjusted Net Income, such as EBITDA) or if the Retained Earnings of the business is allowed to drop below a specified amount. It is also not uncommon for the Financial Covenants to include more complex targets, such as ratios of cash flow to debt service. Under these covenants, the borrower is in default if their modified cash flow (again, usually based on EBITDA or some modified EBITDA) is not at least a specified multiple of the cash required to meet the scheduled payments under the loan(s). A ratio of 1.1:1 to 1.25:1 of EBITDA to debt service is fairly common. These are but a few examples of the dozens of Financial Covenants we have seen in commercial loan documents.

Restrictive Covenants are almost always present in commercial loan agreements. These covenants are typically easier to understand than are Financial Covenants and easier for the management of the business to control. An example of a Restrictive Covenant includes an agreement by the borrower that it will not borrow funds from other sources without the permission of the bank until the bank’s debt has been paid in full.

When a client of Penzien & McBride, PLLC is negotiating the terms of a commercial loan, our business attorneys sit down with the owners and managers of the client to make sure they understand what they are covenanting. We then work with management to run the current numbers and the projected future performance numbers to determine how much room for downward adjustments the business can sustain before finding itself in a catastrophic default that could end the business.

When it comes to commercial loan covenants, what you don’t know can certainly hurt you. If you would like to talk to a business attorney about the terms of your commercial loan agreement, call the law firm of Penzien & McBride, PLLC at (586) 690-4400 or email attorney Matt McBride at m.mcbride@penzienlaw.com.

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