Loan Covenants & Their Effects on Small Businesses & Startups

Loan Covenants & Their Effects on Small Businesses & Startups

Securing funding is often crucial for growing a business. However, when taking out a loan, you'll often be subject to loan covenants, which are agreements that restrict how you can manage your company's finances. 

While loan covenants are designed to protect the lender's investment, they can have significant impacts on your company's debt obligations, overall business operations, and even future success.

In this blog post, we'll dive into what loan covenants are, how they work, and their effects on businesses in the tech industry.

By understanding these important financial agreements, you can make more informed decisions about financing and set your startup or business up for success, whether you’re in the life sciences, biotechnology, biopharma, or tech industry. 

What Is a Loan Covenant?

A loan covenant refers to any type of provision in a loan agreement between a borrower and lender that outlines certain conditions or requirements the borrower must adhere to during the term of the loan, such as maintaining a certain level of cash flow or profitability.

However, you may come across other terms like debt covenants or financial loan covenants, which can often be used interchangeably. In reality, they differ in meaning depending on the context.

Debt covenants are similar to loan covenants in that they are also agreements that govern the terms and conditions of a loan, but they may refer to a broader set of obligations beyond the loan agreement, such as bond or credit agreement covenants.

Financial loan covenants are a type of loan covenant that focus on a borrower's financial financial performance, such as maintaining a certain level of financial ratios, metrics, liquidity, or working capital.

These covenants are designed to ensure that the borrower maintains a strong financial position during the term of the loan, and can repay the loan in a timely manner.

It can be helpful to consider each term as a different type of financial requirement that lenders may impose on borrowers as a condition of obtaining a loan.

Loan covenants are specific and often relate to the borrower's operations, while financial loan covenants relate specifically to financial metrics. Debt covenants can encompass a broader set of obligations that go beyond the loan agreement.

How Does a Loan Covenant Work?

Generally speaking, a covenant will outline a certain financial and/or operating metric that the borrower must maintain during the loan term.

The lender typically requires audited financial statements as a condition of the loan agreement to ensure compliance. If the borrower violates a loan covenant, the lender has the right to declare a technical default and demand immediate repayment of the loan.

As mentioned in the previous section, examples of loan covenants can include maintaining a minimum level of cash flow, revenue, or profitability, complying with certain financial ratios such as debt-to-equity or interest coverage ratios, and restrictions on the borrower's ability to take certain actions, such as incurring additional liabilities or making large investments.

There are often several covenants included in the credit agreement or loan contract the lender and borrower agree to sign in order to issue the loan. This legal document typically details the full list. It also includes other terms specific to the loan, including the loan amount, interest rate, and repayment schedule, among others.

Loan covenants aim to ensure that the borrower uses the funds in a responsible manner and meets all their financial obligations while repaying the loan. If the borrower violates a loan covenant, the lender has the right to declare a technical default and demand immediate repayment of the loan. This is also known as a covenant breach.

Banks include covenants in loan agreements to protect their position and increase the likelihood that the borrower will fully adhere to the terms and conditions of the loan and repay in full.

There are standard and non-standard covenants, which simply means there are some covenants that are standard for all borrowers. When non-standard covenants come into play, they’re based on the unique characteristics or risks of a borrower.

In this way, some covenants can be tailored to the specific needs or attributes of the borrower. Non-standard covenants vary depending on factors like the size and nature of the loan, the creditworthiness of the borrower, and the risk level of the investment.

When used fairly, loan covenants can be used to align incentives between a lender and a borrower or to mitigate borrower or transaction-specific risks that may otherwise be unavoidable.

However, loan covenants can be unfair and restrictive if not carefully reviewed and negotiated (if possible) by both the borrower and the lender. In some cases, they may prevent the borrower from pursuing growth opportunities or making necessary investments in their business.

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What are Some Types of Loan Covenants?

There are several types of loan covenants and different ways to categorize them beside standard and non-standard. Some types include affirmative, negative, financial, operating, reporting, and event of default loan covenants.

For brevity’s sake, we’ll focus on three of the most common types of loan covenants: affirmative, negative, and financial.

Affirmative Covenant

This type of covenant, also referred to as a positive covenant, requires the borrower to take certain actions (i.e., things they must do), including things like maintaining insurance coverage or providing financial reports to the bank, in order to ensure that the borrower is complying with the loan agreement. This means you’ll see language like “the borrower must'' and “the borrower will.”

Negative Covenant

This type of covenant prohibits the borrower from taking certain actions (i.e., things they must not do) that could negatively impact the borrower's ability to repay the loan. This can include incurring additional debt or selling assets. You’ll see language that includes “the borrower must not” and “the borrower will not.”

Financial Covenant

This type of covenant requires the borrower to maintain certain financial ratios to ensure that the borrower has sufficient cash flow to repay the loan. This can include things like debt-to-equity or interest coverage ratios and are specific to the borrower’s financial figures and performance.

Why Are Covenants Included in Loan Agreements?

The purpose of loan covenants is to provide lenders with some level of assurance that the borrower will be able to repay the loan.

By requiring borrowers to meet certain financial and operating metrics, loan covenants help ensure that the borrower remains financially sound throughout the life of the loan. They also provide lenders with some level of protection against the borrower taking actions that could negatively impact their ability to repay the loan.

In other words, covenants help lenders protect their investments and minimize the risk of defaults.

Loan covenants can also benefit borrowers by providing them with a clear set of expectations and guidelines to follow during the loan term. By meeting the covenants, borrowers can demonstrate their creditworthiness and financial discipline, which can help them access additional financing in the future.

Loan covenants can be both good and bad, depending on the circumstances. On the one hand, loan covenants can help protect the interests of lenders and minimize the risk of default.

By requiring borrowers to maintain certain financial and operating metrics, lenders can feel more confident about the borrower's ability to repay the loan. Additionally, loan covenants can help borrowers stay on track and maintain financial discipline, which can ultimately benefit them in the long run.

On the other hand, loan covenants can also be a bad thing in certain situations. For example, if loan covenants are too restrictive or onerous, they can limit a borrower's ability to operate their business effectively.

This can be particularly problematic for businesses that are growing or undergoing significant changes, as the covenants may not be flexible enough to accommodate these changes. In some cases, loan covenants can also lead to conflicts between lenders and borrowers, especially if the borrower feels that the covenants are too restrictive or unfair.

Moreover, there may be situations where the borrower may find it challenging to meet the covenants due to external factors, such as economic downturns or unexpected events. This can result in the borrower being penalized or even defaulting on the loan, which can have serious consequences for their business.

What are Covenant Breaches?

Covenant breaches are violations of the loan covenants outlined in a credit agreement between a borrower and lender.

When a borrower breaches a covenant, it is considered an event of technical default and can have serious consequences for the borrower. Covenant breaches are reviewed by a risk manager and documented in writing by the lender as they violate the credit agreement.

However, not all covenant breaches are created equal. Some covenant breaches, such as late financial reporting, may be resolved quickly and have minimal impact on the borrower.

Other covenant breaches, such as failing to meet debt service coverage ratios or breaching debt-to-equity ratios, may result in the borrower receiving an accelerated repayment notice from the lender.

In more severe cases, covenant breaches may have immediate and serious legal consequences for the borrower. For example, presenting fraudulent financial results to a lender would be considered a severe technical default that could lead to legal action against the borrower.

The Pitfalls of Loan Covenants for Borrowers

Loan covenants are a standard part of securing a loan. However, they can become pretty restrictive when the terms place an undue burden on the borrower, limiting their ability to operate their business or manage their finances effectively.

We covered why covenants can be a bad thing depending on the circumstances, but let’s take a closer look at the factors that can make them restrictive or unfair:

Excessive Financial Ratios

Loan covenants that require the borrower to maintain specific financial ratios that are too high can be restrictive and unfair. For example, requiring a debt-to-equity ratio of 1:1 may require more work for some businesses to achieve and maintain.

Limited Flexibility

Some loan covenants may restrict the borrower’s ability to take on other debt, limiting their growth and ability to seize new opportunities.

Restricted Funds

Some covenants can restrict the borrower's use of the loan proceeds, limiting their ability to invest in their business or make other necessary expenditures.

Excessive Reporting Requirements

Loan covenants that require extensive reporting and monitoring can be burdensome for the borrower, particularly if they need more resources to meet these requirements.

Short Repayment Terms

Loan covenants that require the borrower to repay the loan within a short period may be unfair if the borrower does not have the cash flow to meet these obligations.

Default Risk

Failure to comply with bank loan restrictions can result in default, which can lead to additional fees and penalties, damage to the borrower's credit rating, and even legal action.

Equipment Loan vs. Lease in the Context of Loan Covenants

Because we’re a lab equipment leasing company, we want to compare using an equipment loan vs using a lease to acquire equipment.

The key similarity between the two is that they are both solid options businesses can use to acquire new equipment. However, there are some differences.

Primarily, and in the context of this blog post, lenders often include loan covenants in loan agreements to protect their investment and mitigate risk. In contrast, equipment leases involve renting equipment for a set period, with the lender retaining ownership. When you lease with Excedr, leases do not include loan covenants.

And while leases can be more expensive than loans in the long run, it doesn’t always make sense to take out a loan when it comes time to acquire new equipment. Loan covenants can play a large role in that. It's important to weigh the pros and cons of each option before deciding.

For us, it’s a no brainer. If you want to avoid restrictive financing terms like debt covenants, collateral, IP pledges, and equity participation, lease with Excedr. 

Avoiding restrictive loan terms can make it easier for you to raise money in the future, while still getting the equipment you need to improve your business.

In Summary

In conclusion, loan covenants are important financial agreements that can have significant impacts on your business. While they aim to protect the lender's investment, they can also restrict how you manage your company's finances and operations.

By understanding loan covenants and their effects, you can make more informed decisions about financing and set your business up for success.

If you're interested in equipment leasing or any other type of financing for your business, it's crucial to educate yourself on loan covenants before signing any agreements. You'll be better equipped to navigate the financing process and secure the funding your business needs to grow.