What to expect regarding covenants in loan agreements

Mike Dalton, Vice President of Commercial Lending, National Bank and Trust

If you’re seeking a business loan, chances are you’re going to have some covenants written into the loan agreement.

“Covenants are basically additional terms in a loan agreement, usually to set financial guidelines for a company,” says Mike Dalton, vice president of commercial lending at National Bank and Trust. “I would expect that more than 99 percent of all loan agreements have covenants of some sort. You can pretty much count on a loan having covenants about collecting financial information.”

Smart Business spoke to Dalton about loan agreements and what business owners need to know about covenants.

What are some typical covenants?

Probably the most common are financial statements — requiring that the borrower provide annual tax returns, monthly operating statements in the form of balance sheets and income statements. A covenant that the borrower provides the lender with up-to-date financial information is very commonplace and put on virtually every loan.

Beyond that, a cash flow covenant of some sort is common. This can be measured in a number of different ways, but the covenant basically says that the company needs to maintain, whatever its debt service is, a certain percentage of that debt service over and above through profits and/or after distributions. Outside of the financials, common covenants involve current ratios and leverage ratios, whether debt to asset or debt to equity.

Are covenants solely to protect a bank’s interests, or do they provide any benefits for borrowers, as well?

It’s really mutually beneficial. From a bank’s standpoint, it is risk management, and loaning money is managing the risk of getting that money back. But covenants are certainly guidelines that are going to make a company healthier and are going to help a company potentially weather a down economy or a bad contract it took a loss on. If covenants make sure the business is maintaining appropriate liquidity ratios, they will help the company get through a bad situation. While the bank sets them, covenants are certainly a benefit to the borrower, as well. These are elements that can keep a company healthy and viable through a potential downturn.

Do business owners usually negotiate covenants, or do they use consultants?

It’s probably 50/50, depending on the size of the business. With a smaller, mom-and-pop operation, it’s likely going to be strictly a conversation between the bank and the business owners. When you get into larger companies, it’s not uncommon to have a CPA involved. Potential borrowers are always encouraged to consult with their CPAs.

Are banks dictating terms, or is there a give and take?

I would say they’re somewhat negotiated items. Ninety-plus percent of the time, it’s just a normal conversation sitting across the desk from a business owner and discussing a loan request, identifying strengths and weaknesses, and coming to a mutual agreement on rates, terms, etc., that are acceptable to both parties.

What happens if a covenant is not met?

There is some kind of penalty. It could be a one-time fee or a higher interest rate until that covenant is corrected.

Typically, it’s an interest rate bump — if a business has missed the covenant, the interest rate goes up by 1 percent, 2 percent or 3 percent until the business gets back into compliance with the covenant. If the borrower drops below its current ratio covenant, you’ve got a company that doesn’t have the appropriate amount of liquidity, so the bank’s risk goes up. Therefore, the rates are raised an appropriate amount. Loan rates, especially in commercial lending, are priced based on risk — the lower the risk, the lower the rate. Another way it’s done is a one-time fee where the bank says, ‘We’re going to measure this covenant at year-end, and if you miss it, we’re going to assess a penalty of a certain amount of dollars.’

If the interest rate can go up, is there anything a borrower can do that would lower its rate?

Anything that lessens the bank’s risk is going to lessen the rate. The borrower could provide additional collateral. If it has an acceptable current ratio now, could it ask, ‘If I increase my current ratio above this, can I get a lower rate?’ Sure.

Other than covenants, is there anything else business owners need to understand about loan agreements?

A loan note itself, other than the covenant section, is 90 percent boilerplate. The bank fills in a few blanks as far as loan amount, interest rate and payment amount, but the overwhelming percentage of a loan agreement is boilerplate legalities. They’re pretty standard; most banks use one particular software system. It’s a two-page note and the second page of the note is identical on every loan and goes over definitions of how the bank calculates interest, what makes a default and what remedies the bank has to collect on the loan in the event of a default. That’s the boilerplate section.

Mike Dalton is vice president of commercial lending at National Bank and Trust. Reach him at (937) 382-1441 or [email protected]

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