Small business owners almost always have to ask for a loan at some point. It’s important to remember that when requesting a loan, you will have to deal with the issue of covenants. These are constraints lenders impose on your company to keep it operating within specified financial ranges, and to prevent your small business from taking certain actions.
Of course, the lender wants to mitigate risk and be sure that they will get their money back, which is the purpose of the covenants. But if you as a business owner are not careful, they can put your company in a stranglehold. Sometimes business owners can be forced into paying the loan in full immediately if the company violates a covenant. Typical commercial-loan covenants can require your business to, among other things:
- Hold a minimum credit balance on deposit
- Maintain specific financial ratios. These can include working capital as well as tangible net worth
- Keep collateral property insured and in good repair
- Provide periodic financial statements and tax returns
- Avoid taking on additional loans or other debt
- Keep the current management 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. Even with these covenants, you still need the flexibility to run your small business prudently. Some loan requirements set sound benchmark metrics that can help keep your company healthy. However, others 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 business loan:
1. See it from the lender’s perspective. 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, involve several different 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 business.
3. Ask “What If.” Once you have analyzed your company’s financials and know how different covenants might affect your business operations, start talking options with your lender. This is a chance for you and your banker to feel each other out and determine each other’s expectations before settling on 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. Ensure that inadvertent or unintentional defaults will not be triggered without your business receiving prior notice and having a chance to fix the problem.
Remember that some give and take is required to reach a compromise. You and your lender might agree to a limit on the number of late payment notices allowed before your business is in default, for example. The goal is to make it easier for your company to avoid default while assuring the lender that its interests will be protected as well.
Although you have to expect to agree to certain covenants when your business takes out a commercial loan, get guidance from Filler & Associates on how to effectively negotiate fair and reasonable terms that you don’t inadvertently violate.