Business loans have typical documentation you will find with all loans: promissory note, agreement to provide insurance, title insurance, etc. But, often the loan will be accompanied with additional documentation that is not common with consumer lending. The “loan agreement” is probably the single most unusual document that tends to accompany business loan requests.
A loan agreement is an agreement between the borrower and the lender that certain provisions will be met as part of the ongoing extension of credit. This is necessary, because in business loans we want to identify potential issues in advance before they affect repayment so we have time to prepare, restructure, or reconsider our decision to provide credit.
If the nature of the business changes, repayment can be greatly affected. The loan agreement helps us reach an understanding with the borrower, in which we expect them to operate their business in a certain way. We don’t want them to change things so much that it may affect how we originally understood their plan for repaying the loan. We may be asking the borrower to agree not to take on other debt without first consulting with us, or make certain they maintain base level of operating income that can satisfy the required payments on the loan.
The agreement can also specify conditions unrelated to payment. If the borrower is a hotel, we may ask they do not change their franchised name, so they don’t become an unknown hotel that has difficulty attracting customers. It is also common that the borrower agrees to regularly supply us with financial information, so we can monitor their financial condition.
These different deal points come to be known as loan covenants. If the borrower fails to meet a covenant, they have technically defaulted on their loan. If a customer is still paying as agreed, but has broken a covenant, we say they are in “technical default.” An event of default usually allows the lender to exercise certain decisions to better protect their odds of repayment, including forcing immediate repayment of the loan.
What decisions the lender choses to exercise with a covenant violation often depends on the seriousness of the violation. If the borrower has engaged in a risky behavior, which has led to the covenant violation, perhaps it makes sense for a lender to call the loan due. On the other hand, if a covenant is broken because the borrower is slow to produce financial statements, but there is otherwise no cause for concern, there may be little or nothing done or said.
If a covenant is violated because the borrower has failed to meet certain financial benchmarks, the lender has a lot to consider. Perhaps the benchmarks were not set correctly in the first place. Maybe the financial condition of the borrower has deteriorated, but they are still viable and capable of repaying the loan. It is in these situations that a lender must chose to restructure the loan, waive the violation, or even start charging penalties for the added risk or work required to monitor the situation.
It is for these reasons that having loan covenants is a good idea. The borrower and the lender are able to layout expectation upfront through a loan agreement, and then the lender has options and recourse should the borrower fail to meet provisions in the loan agreement. It is important that the lender does not overreact when a covenant is broken, but rather consider the seriousness of the specific covenant and what a measured approach going forward should be.