Loan Covenants: The Three Types of Promises

Banks include loan covenants in their loan agreements to preserve their position as lender
and to improve the likelihood the loan will be paid back by the borrower on time and in full. A
covenant is simply a fancy term for the word promise.

Bank Loan Agreements May Include Three Types of Loan Covenants:

Affirmative Loan Covenants
An affirmative loan covenant is used to remind the borrower that they should be doing certain
things for the health and well-being of the business. These promises may include things such
as:
Pay all of its business and employment-related taxes
Maintain current financial records and reports
Maintain insurance policies for the business and possibly include the bank as an
additional insured.
Maintain its present legal status or entity

Negative Loan Covenants

A negative loan covenant is used to create boundaries for the company and its owners. Such
boundaries are usually related to financial and ownership matters such as:
Limiting the total amount of indebtedness for the business and/or shareholders
Restricting or forbidding distributions and/or dividends paid to shareholders
Restricting or forbidding management fees paid to related parties
Preventing mergers or acquisitions without separate permission
Preventing investment in capital equipment, real estate or other businesses without
separate permission
Preventing sale or divestiture without separate permission
Maintaining a specific or targeted Debt Service Coverage Ratio

Financial Loan Covenants

Financial loan covenants are used to measure how closely the business performs against the
financial projections provided by the entrepreneur, CFO, or management. Certain financial
loan covenants may be used to restrict the amount of credit the business accesses from its
line of credit. Such measurements may include:
Current Ratio (Current Assets divided by Current Liabilities)
Borrowing Base Calculation where a defined maximum percentage is applied against the
business eligible Accounts Receivable to determine how high a Line of Credit may be drawn.

Are Bank Loan Covenants Negotiable?

Absolutely yes! Loan covenants are negotiable between the bank and the entrepreneur.
Entrepreneurs should note that they may unintentionally find themselves in violation of a loan
covenant which may become a serious matter. Some banks automatically turn their business
accounts in violation of a bank covenant over to the Workout or Special Assets Group for
resolution. Should this happen, an entrepreneur may be forced to source an alternative
source of business capital to grow their business.