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What are Business Loan Covenants and Why Are They Used?

Business loan covenants are designed to insure that a bank or financial institution that is lending money is protected from any potential default. These covenants can take a variety of forms and vary from bank to bank depending on the strength of your company, your personal financial situation, the specific nature of your loan and your relationship with the lender. It is prudent to insure that all the conditions of a loan are understood and it is also important to note that many items that may be proposed as loan covenants are negotiable either with the bank you are dealing with or with another potential lender. The impact of failing to comply with the loan covenants may be an immediate call for payment on the note so it is critical to understand the details of the loan covenants. Some common types of covenants are described below.

Licenses and taxes – the bank typically wants to insure that all taxes and licenses are kept up to date. The reason for this covenant is that any potential non-payment of these expenses could result in a lien against the business and a lien of this sort takes precedence over any demand for payment of another debt.

Life Insurance – the bank typically requires that life insurance be acquired for the owner and any critical partners or management personnel whose death or incapacitation might adversely affect operations. The bank will require assignment of these policies to them.

Equipment Insurance – if the note is being acquired to purchase any equipment or tangible property that might be subject to fire, theft or other type of loss, the bank will typically require insurance which will name the bank as the first payee in the event of any catastrophe or loss.

Financial Statement – the bank will require a current financial statement and demand that it be updated periodically. The may be quarterly, semi-annually or annually depending on the amount that is being borrowed and the strength of the company or individual that is seeking the loan.

Other Covenants – there are a multitude of other covenants that may be imposed on a borrower. These may include restrictions on the sale of assets, the maintenance of certain financial ratios that are used to determine the health and well-being of a company, a prohibition that insures that a company will not acquire additional debt and many other potential restrictions.

As is illustrated above, business loan covenants can take many forms and may be so restrictive that it is not practical to accept the conditions. It is important to note that banks and other lending institutions vary widely in their covenant policies and shopping around for a potential loan is extremely important. Remember, you are purchasing a product – in this case money and that familiar term "caveat emptor" - "let the buyer beware" is applicable.

Research will reveal that some banks require no or minimal covenants for some types of loans. Of course the downside of no covenants may be a higher interest rate on a loan. The bottom line concerning loan covenants is to research, negotiate and determine what best fits your specific overall business strategy.

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