If you’re about to ask for a business loan, expect to deal with the issue of covenants – constraints lenders impose on your company to keep it operating within specified financial ratios and to prevent it from taking certain actions.

These clauses are meant to help the lender mitigate risk and get its money back. But if you are not careful, they can put your company in a stranglehold. Under some very strict loan agreements, if your firm violates a covenant, it can automatically go into default and be forced to pay the loan in full immediately. Typical commercial-loan covenants can require your business to, among other things:

• Hold a minimum credit balance on deposit;
• Maintain specific capital or financial ratios, such as tangible net worth, working capital and debt servicing;
• Keep collateral property insured and in good repair;
• Provide periodic financial statements and tax returns;
• Avoid taking on additional debt or borrowings; and
• Keep the current management or ownership structure.

When considering a loan, you want to try to at least loosen, if not eliminate, the obligations that will be most difficult for your business to meet. Try to negotiate covenants that leave you the flexibility to run your business prudently. Some loan requirements set sound benchmark metrics that can help keep your company healthy. Others, however, could be too difficult to meet and result in disastrous consequences.

Here are four important considerations before you officially ask for – or agree to – a commercial loan:

1. Take your lender’s perspective. Your loan officer has to deal with internal policies and external regulators and, depending on the size of the loan, may have to persuade a formal loan committee that the loan presents no undue risk given the covenants involved. Gather up your business and strategic plans, financial projections and other relevant financial information and try to come up with a set of covenants you would expect the bank to require as well as a set your organization can live with. Keep in mind that the loan panel will be looking at how profitable the lending relationship will be for its company.
2. Run some critical calculations. Some financial covenants, such as debt service coverage ratios, liquidity and performance ratios, and current ratio/working capital, involve several financial statements. Take the time to run various scenarios through your company’s most recent financial statements to determine which covenants would be the best and worst for your operation.
3. Ask “what if.” Once you have analyzed your company’s financials and have a grasp of how sensitive potential covenants will be to changes in your projections, start discussing matters with your lender. Keep the talks on the level of simply asking “what would happen if …”   This is a chance for you and your banker to feel each other out and determine each other’s expectations before drafting a formal agreement.
4. Avoid strict technical default clauses. This is critical. The default section of the loan agreement gives the lender the right to demand immediate repayment of the loan if your business does not live up to a covenant. You need to be sure that inadvertent or unintentional defaults will not be triggered without your business receiving prior notice and having a chance to take care of the problem.

For example, if you have a monthly fixed-rate loan, the bank could argue that your company’s financial controls should make such notice unnecessary. You, on the other hand, could maintain that missed deadlines can sometimes result from computer malfunctions or business trips where executives with check-signing authority are out of town. This type of discussion could be sparked by each default provision. Some give and take is required to reach a compromise. For instance, you and your lender might agree to a limit on the number of late payment notices allowed before your business is in default. The goal is to make it easier for your company to avoid default while assuring the lender there are adequate mechanisms in place to protect its interests.

Although you have to expect to agree to certain covenants when you take out a commercial loan, get guidance from your accountant as well as your attorney on how to effectively negotiate fair and reasonable terms that you don’t inadvertently violate. It could accelerate a premature demand for repayment and cause financial hardship for your company.

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