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Covenants in Commercial Loans: A Guide to Commercial Loan Covenants in Canada
7 Park Avenue Financial originates business financing solutions for Canadian Businesses – We offer Business Financing and working capital solutions – Save time and focus on profits and business opportunities
7 Park Avenue Financial: “Canadian Business Financing with the intelligent use of experience”
"The best way to keep one's word is not to give it." - Napoleon Bonaparte
At 7 Park Avenue Financial, we're pretty sure Napoleon Bonaparte wasn't talking about loan covenants, but we think it's all about thinking about commitments before you make them—That's the issue around loan covenants!!
Commercial lending in Canada, when it comes to a secured loan, typically always involves credit agreements that outline covenants.
What are they, and how do you address the pitfalls and dangers of this method that lenders use to protect themselves (and you, by the way) from business default and failure? Let’s dig in.
COVENANTS ARE NEGATIVE AND POSITIVE
When it comes to the agreements you make with any secured lender in Canada around a financial covenant in a credit agreement, it comes down to the ‘yay’ and ‘nay’.
What we are talking about is known as ‘affirmative’ and ‘negative’ scenarios. Affirmative actions are those you can take or do, sometimes with permission required. Negative ones are those you cannot take in the ordinary course of running your business.
Credit agreements commonly include standard loan covenants to outline the behaviours and circumstances necessary for the loan's legal enforceability.
WHAT ISSUES AFFECT YOUR LOAN AGREEMENT
What are the typical scenarios the Canadian business owner or manager takes that might affect your loan agreement? They might include:
Raising more equity capital
Selling certain assets of the business
Taking on additional debt can impact the borrower's existing debt obligations (that’s a big one with lenders!)
Draining cash flow in some manner
Remember always that the proactive thing to do is to discuss actions you wish to take that affect the lending agreement.
When they are common-sense business actions, a (reasonable) lender will almost always allow them. A good example might be taking on more debt by acquiring new production equipment or technology that makes your business more profitable.
NEGOTIATING COVENANTS!
The thing about loan covenants for small businesses that is often overlooked by the borrower is that while they generate a lot of discussion and negotiation (yes, they can be negotiated!) at the start of loans, they must, in fact, be maintained during the duration of the secured loan / commercial lending arrangement.
So what happens when those debt covenants are breached?
The harsh reality is that you are in default on your commercial loan, and typically, all monies are due. Breaching a debt covenant can lead to technical defaults and penalties and may require negotiations with the lender to manage the breach.
WHAT TYPES OF FINANCING HAVE FEW OR NO COVENANTS
We point out to clients that many types of loans in Canada have no or very few loan covenants outlined in their loan contracts, especially in alternative funding.
Examples typically include asset-based lines of credit, receivable financing, equipment finance, and tax credit monetization. If there are any covenants in those arrangements, it’s typically because your overall balance sheet and income statement dictate that.
Remember also that all arrangements defined in your loan agreements are not necessarily negative.
For example, if you can negotiate pre-payment arrangements in your favour, that’s a good thing. Also, certain actions you take might make sense for you and the lender to pay down loans - for example, new equity or sale-leaseback scenarios with another lender.
WATCH FINANCIAL COVENANTS!
The huge issue around business loans and commercial lending agreements with lenders in Canada is ‘ RATIOS ‘.
Lenders have many guys in the backroom constantly running your business's liquidity, leverage, and operating ratios for those loan documents. You can proactively manage these ratios by understanding them and calculating them yourself—trust us, it’s not that easy.
Maintaining a healthy debt service coverage ratio (DSCR) ensures sufficient financial performance to support loan repayment.
KEY TAKEAWAYS
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Financial covenants establish specific ratios and metrics borrowers must maintain, ensuring fiscal health and stability.
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Affirmative covenants require businesses to take certain actions, such as providing regular financial statements and maintaining insurance coverage.
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Negative covenants restrict borrowers from engaging in activities that could jeopardize their ability to repay the loan.
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Covenant breaches may trigger default events, potentially leading to loan acceleration or renegotiation of terms.
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Regular reporting and compliance monitoring help lenders and borrowers track covenant adherence and proactively address potential issues.
CONCLUSION
Covenants in commercial loans are essential contractual clauses that define the terms and conditions under which a business can maintain its borrowing relationship with a lender.
When it comes to commercial lending and secured loans that make sense to you (and the bank or commercial lender), seek out and speak to a trusted, credible and experienced Canadian business financing advisor who can assist you with your secured loan needs.
FAQ
How can well-negotiated covenants benefit my business?
Well-negotiated covenants can lead to better loan terms, lower interest rates, and increased borrowing capacity as they demonstrate your commitment to financial discipline and transparency.
What role do covenants play in maintaining a healthy lender-borrower relationship?
Covenants foster open communication, regular financial reporting, and proactive problem-solving before a borrower fails , strengthening the relationship between your business and the lender.
Can covenants help my business improve its financial management practices?
Yes, covenants often require businesses to maintain specific financial ratios and metrics, encouraging better financial management and performance tracking.
How might covenants impact my company's growth plans?
While covenants may seem restrictive, they can actually support growth by ensuring your business maintains financial stability and discipline as it expands.
Are there ways to use covenant compliance to my advantage when seeking additional financing?
Consistent covenant compliance demonstrates your business's reliability and financial health, potentially making it easier to secure additional financing or more favourable terms in the future.
What happens if my business experiences a temporary setback and cannot meet a covenant requirement?
If you anticipate difficulty meeting a covenant in a loan contract/agreement, it's best to communicate proactively with your lender. They may grant a temporary waiver or amendment to the covenant terms and sometimes amend the interest rate based on financial statement quality.
How often are covenants typically reviewed or renegotiated?
Covenant terms are usually reviewed annually or when significant changes occur in your business or the economic environment. However, this can vary depending on the lender financial institution and the loan agreement or the property financial statements if real estate is involved.
Do different industries have specific covenant requirements?
Yes, covenant requirements can vary by industry. Lenders often tailor covenants to reflect the unique characteristics and risks of different sectors. Some lenders, but not all, will require audited financial statements of the borrowers financial performance based on loan amount or overall risk of a covenant breach.
Can covenants change over the life of the loan?
Covenants can be adjusted over time through amendments to the loan agreement. This might occur as your business grows, market conditions change, or if the initial terms prove to be unrealistic.
Are there any alternatives to traditional covenant structures?
Some lenders offer covenant-lite loans with fewer restrictions, but these typically come with higher interest rates or are reserved for larger, more established businesses.
What are the most common types of covenants found in commercial loans?
The most common types include financial covenants (such as debt-to-equity ratios and minimum working capital requirements), affirmative covenants (like maintaining insurance and providing financial statements), and negative covenants (restrictions on additional borrowing or major asset sales).
How can a business prepare for covenant negotiations with a lender?
To prepare for covenant negotiations, a business should thoroughly understand its financial position, growth projections, and industry benchmarks - Thats what lenders typically require - It's also helpful to engage financial advisors or legal counsel with experience in commercial lending.
What strategies can borrowers use to manage covenant compliance effectively?
Effective covenant compliance strategies include implementing robust financial reporting systems, regularly monitoring key metrics, maintaining open communication with lenders, and proactively addressing potential issues before they become covenant breaches.
ABOUT 7 PARK AVENUE FINANCIAL
7 Park Avenue Financial originates traditional and alternative financing and asset-based financial services providers that offer lease financing, cash flow and working capital financing, and business acquisition loans.
The company works closely with clients to develop key business strategies based on their unique needs. The company is committed to providing the highest level of customer service and innovation to help businesses succeed.
Combining our experience and solutions, we help our clients achieve profitable cash flow and debt financing and streamline the process with a full range of credit offerings.
