Loan Covenants Explained

Loan covenant

When a lender makes a loan they typically ask the borrower for “covenants” to protect their position. A loan covenant is simply a promise by the borrower to the lender to help set expectations and guide future behavior. They are generally classified as either operational or financial and further as affirmative or negative. Understanding the covenants contained in the legal documentation is an important step to building a strong relationship with your lender.

An affirmative covenant requires a company to meet or maintain an item while a negative covenant seeks to restrain specific actions or financial performance. Research has shown that almost 100 different covenants could exist but a typical lower middle market loan (involved in a Management Buy Out (“MBO”), a growth capital loan, a Leveraged Buy Out (“LBO”), or an acquisition loan) will have 10-30 covenants.

For example, if a company earning $3.0 million in EBITDA borrows $7.0 million from a lender it is reasonable for the lender to ask the borrower for certain promises such as to: (a) operate the business within the law, (b) pay its taxes, and (c) share monthly financial updates in a timely manner, etc.

Additionally, a lender will typically define and measure performance against certain financial covenants such as: (a) debt service ratio, (b) fixed charge coverage ratio, (c) debt-to-equity ratio, (d) total funded-debt-to-EBITDA ratio, and (e) minimum EBITDA and availability, with the goal being to have the borrower maintain its cash flow, asset and equity values and the overall collateral position as well as avoiding over-leverage and adequately covering the company’s fixed charges.

At F.N.B. Capital Partners our most commonly used financial covenant is the fixed charge coverage ratio which is used to examine the extent to which fixed costs (such as cash interest, term loan repayment, taxes and capital expenditures) consume the cash flow of a business. The goal is to have our borrowers maintain an acceptable margin of safety, typically in the 1.10-1.25x range depending on the risk profile of the company.

If a financial ratio covenant is breached or “tripped” it puts the borrower into a technical default of the loan agreement and a lender’s reaction could range from reasonable (work together to put a plan in place to regain compliance) all the way to foreclosure, depending on the severity of the issues. We encourage all business owners to approach covenant discussions proactively with open communications and realistic expectations.

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