A covenant is a promise that a borrower makes to a lender as part of a business loan agreement
When giving out a business loan, a lender will often ask a borrower to respect certain conditions that go beyond simply paying back the money. These promises made to the lender are called covenants.
Although there is no standard covenant that will appear in every business loan, two common ones are “keep-well clauses” and “hard financial measures.”
- A keep-well clause describes what your company will or will not do while the loan is still outstanding. For example, it may require you to keep the same management team in place—and to agree not to sell any part of the company or incur additional debt—for the duration of the loan.
- Hard financial measures are financial ratios you are expected to meet throughout the lifetime of the loan. These could stipulate that you maintain a debt-to-equity ratio of 3:1, or a current ratio of 2:1 or better, or perhaps a Debt Service Coverage Ratio of 1:1 or better.
Covenants are reviewed at least once a year and may be adjusted should conditions change. When a borrower breaks a covenant, the loan may technically be in default because its terms are not being met.
How do covenants work?
When a business borrows money from a financial institution, the loan terms are outlined in a loan or lending agreement. These include the loan amount, interest rate and repayment schedule. But they may also include one or more covenants.
Covenants are clauses in the agreement that require the borrower to do or avoid doing certain things and are often tied to the business’ financial performance. A single agreement can include multiple covenants.
While they can come in different forms, they are essentially rules that a business agrees to follow throughout the life of the loan or during a particular time frame. If a business violates a loan covenant, it is technically considered in default of the loan.
Why are covenants used in loan agreements?
When a financial institution issues a loan, it wants to ensure the full repayment of the principal plus interest. Covenants protect the lender’s investment by setting conditions that should help a company pay back the debt—requiring, for instance, that a business maintain adequate cash flow.
Covenants don’t just protect the lender. They can also benefit your business by ensuring it has the mechanisms in place to pay back its loan.
What determines whether a loan will include covenants?
Whether or not a loan agreement will include covenants—and what types of covenants they may be—is determined by various factors, such as the:
- size of the loan
- type of loan
- overall risk assessment
The level of business risk will usually determine whether or not a lender will make a covenant part of your loan agreement. Risk is determined by the financial institution’s overall assessment of your business, including its stage (Is it a start-up? A seasoned player?) and financial strength.
Some financial institutions will put covenants in place to ensure your business adheres to their eligibility policies for financing. For example, if your business takes out a building loan and plans to lease to tenants, covenants in the loan agreement might spell out which types of establishments can or can’t lease a space in the building.
Positive covenants, also known as affirmative covenants, require a business to adhere to certain terms. They might require that the company maintains a certain type of insurance or delivers audited financial statements to the lending institution. For instance, if there was a storage tank on your property containing oil or a toxic chemical, a covenant could require it to hold liability insurance to cover any costs related to a potential leak.
An affirmative covenant may require what is known as a notice-to-reader (now replaced with Compilation Engagement) financial statement (for smaller-sized loans). Once a certain threshold of financing has been reached, an accountant-reviewed financial statement (commonly known as review engagement) might be required. In these cases, the financial reporting acts as a type of insurance.
Negative covenants are more straightforward. They simply restrict a company from engaging in certain actions by setting out things the borrower must not do.
For example, a negative covenant could include restrictions on:
- repayment of shareholder loans
- dividend payments to shareholders
- intercompany transactions
Numerical or financial covenants
Numerical or financial covenants are tied to a borrower’s financial performance and based on the risk inherent in the borrower’s credit structure. These covenants are put in place to ensure your company maintains adequate cash flow to meet the debt obligations set out in the loan agreement and to carry out its operations.
Numerical or financial covenants allow a lender to look at a company’s financial statements regularly to ensure the company is adhering to certain agreed-upon financial terms, such as the:
What is the timeline of a covenant?
How long a covenant remains in place depends on the covenant type. An environmental covenant that calls for a business to hold liability insurance would likely remain in place for the life of the loan. An affirmative covenant that stipulates the business pay its property taxes in full every year would require the same.
Certain negative covenants—such as those that restrict the repayment of shareholder loans, dividend payments made to shareholders, or intercompany transactions—might only be in place for a specified period. Given that the goal of these covenants is to prevent an excessive amount of capital from leaving the company, they are often lifted once the lender is confident that your business is in good financial health.
How are covenants monitored?
How a financial institution monitors a covenant depends on:
- the type of covenant
- the complexity of the loan
- the loan’s risk assessment.
In some cases, the lender may conduct a quarterly or semi-annual review to ensure the company is living up to the terms of the covenant. This is most common with larger, unsecured loans (in excess of $2 million) and where the company lacks tangible security, such as a building or equipment.
A lender will generally review your company’s file annually. Once it has received year-end financial statements, the lender will review all of the covenants in the loan to see if they are being met and to ensure the company is adhering to financing policies.
What happens if a business breaches a covenant?
If your business fails to live up to the terms of a covenant, there are several possible enforcement actions that the lender can take.
- For a minor breach, the lender might simply send a letter informing you that your company is in breach of a covenant. This might be followed by a conversation to find out how you plan to correct the problem, or to determine the underlying cause of the breach, so the lender and business can work together to rectify the problem.
- For a more serious breach, or if a company fails to take corrective action to meet the terms of the covenant, the lending institution can decide to end the relationship with the business and call in the loan.