Whether you’ve already launched your online business or continue to be in the early planning phases, you might be exploring different funding choices to leave the ground, expand, or weather tough times. There are many options for funding a small company, and it can be challenging to know where to start.
When internal capital isn’t enough to cover costs, many smaller businesses take out loans. Before getting started and taking on debt, it’s helpful to familiarize yourself with some of the more difficult terms and lingo you’ll encounter when searching for small company loans.
A debt covenant is one such term you will likely encounter. Let’s take an in-depth take a look at what debt covenants mean for a small company loan, why they’re used, and how to determine if their conditions are a fit for your requirements.
What Is really a Debt Covenant?
Debt covenants are available in various forms, but they could be broadly characterized as a set of restrictions or agreements between a borrower and a lending institution or creditor. They might be also known 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. When the borrower violates these conditions, the lender may have the legal right to impose penalties, terminate the loan, or intervene in certain other capacity.
Why Lenders Use Debt Covenants
When financial institutions, creditors, or lenders grant financing, they are doing so based on an evaluation from the borrower’s ability to pay the loan back with interest. Therefore, it ought to be no surprise that lenders try to minimize the risk of borrowers defaulting on their own loans.
Covenants is one tool in 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, for example expectations and permitted financial behavior, with the aim of getting all parties involved on the same page. Additionally, covenants usually outline measures the lender can take if the agreed-upon terms are violated. A few examples include the following:
- Charging penalties or fees
- Increasing the loan’s interest rate
- Increasing the entire collateral
- Terminating the loan entirely
Altogether, these measures are a way for that lender to lessen risk and recuperate losses when a borrower does not repay financing.
How Covenants Work
The details of a covenant will depend on the lending institution and also the financial status from the small business seeking a loan. But essentially, a debt covenant can be thought of as the rules and types of conditions the borrower are required to follow and fulfill before the loan is repaid.
Many facets of covenants coincide with the successful financial and legal operation of a business, together with a positive rate of growth and compliance with tax law. More complex debt covenant criteria you may encounter include:
- Debt-to-Equity Ratio: While using formula (Total Liabilities / Total Shareholders’ Equity), this metric shows as to the extent a business is financing itself with debt when compared with its very own funds.
- Debt Service Coverage Ratio: This measures a business’s income, and is calculated by dividing net operating income through 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 the business must stay above or below.
Typically, there will be some grace period to fix and remedy a violation, and much more understanding lenders may be willing to enter a discussion or negotiate with borrowers how they’ll proceed 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 towards the termination of a loan.
Types Of Covenants
Covenants can be sorted into two distinct categories: good and bad. The important thing difference is that positive covenants are stuff that borrowers should do, whereas negative covenants represent what you canrrrt do during a loan’s lifetime.
Positive/Affirmative Covenants
Largely known as positive covenants, you may also see these referred to as affirmative covenants. For example of positive covenants in the context of a small company:
- Maintaining satisfactory financial ratios, such as profit ratio, debt-to-equity ratio, and debt service coverage ratio.
- Keeping a particular minimum sum of money.
- Providing accurate financial statements promptly and according to schedule.
- Providing life insurance coverage for designated employees
Negative Covenants
These types of covenants are made to prohibit behavior that could pose a possible 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, like a lease agreement.
- Taking out additional loans or debt.
How Common Are Debt Covenants?
The likelihood of a debt covenant depends on how much money borrowed, the timeframe for repayment, along with a small business’s financial background. Emerging small businesses in particular should be expecting to take on debt covenants to have 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 upon how restrictive the covenants are and also the potential risk of violating their conditions.
It’s important to think through and comprehend the various scenarios by which your company might breach a covenant and consider the potential risk associated with each. If you think maybe both you and your small business are prepared, then by all means, proceed. However, it’s worth comparing lenders to find terms that align together with your needs.
In certain cases, a debt covenant might actually pose benefits for borrowers. For example, accepting debt covenants may help a borrower negotiate a lesser rate of interest or reduce associated fees since the lender has more assurances that the loan will be repaid. Additionally, these covenants might help small businesses better monitor their financial wellbeing and make improvements and adjustments accordingly.
Debt Covenants: The Bottom Line
Debt covenants cover an array of financial, legal, and operational agreements between a lender and borrower. Though they have some caveats, debt covenants might help get the business on the right track and help you in acquiring funding. Using a clear understanding of your small business’s current debt and finances might help see whether a debt covenant is beneficial and practical for you.
