Covenants of the borrower: Overview, definition, and example
What are covenants of the borrower?
Covenants of the borrower are specific promises or commitments made by the borrower to the lender in a loan agreement. These covenants are designed to protect the lender’s interests by ensuring that the borrower maintains certain financial or operational standards throughout the life of the loan. They outline actions the borrower must take or refrain from taking, and they help ensure the borrower remains financially stable and capable of repaying the loan.
Covenants can be classified into two types: affirmative covenants (things the borrower must do) and negative covenants (things the borrower must not do). For example, an affirmative covenant may require the borrower to maintain a minimum level of cash reserves, while a negative covenant might prevent the borrower from taking on additional debt without the lender's approval.
Why are covenants of the borrower important?
Covenants of the borrower are important because they help manage risk for the lender and ensure that the borrower’s business practices remain in line with the loan agreement. By setting clear conditions, covenants help ensure that the borrower’s financial situation remains strong, reducing the chance that they will default on the loan. They also provide the lender with certain rights or actions they can take if the borrower fails to meet the covenants.
For SMBs, understanding and adhering to covenants is essential to securing financing and maintaining good relationships with lenders. Violating a covenant could result in penalties, higher interest rates, or even the calling of the loan.
Understanding covenants of the borrower through an example
Imagine your small business is seeking a loan from a bank to fund expansion. The loan agreement includes several covenants, such as a requirement to maintain a minimum level of working capital and a limit on the amount of additional debt you can take on without the bank’s approval. These covenants are designed to ensure that your business remains financially healthy and able to repay the loan. If your business does not meet these requirements, the lender may have the right to increase your interest rate or demand immediate repayment.
In another example, your business may have a loan covenant that requires you to provide the lender with quarterly financial statements. This ensures the lender is aware of your business's financial health and can monitor whether you are staying on track with the terms of the loan.
An example of covenants of the borrower in action
Here’s how covenants of the borrower might be referenced in a loan agreement:
“The borrower agrees to the following covenants: (1) maintain a minimum working capital of $500,000 at all times; (2) limit total debt to no more than 50% of equity; and (3) provide quarterly financial statements to the lender within 30 days of the end of each quarter.”
Conclusion
Covenants of the borrower are key provisions in a loan agreement that outline the borrower’s obligations and restrictions. These covenants help lenders ensure that the borrower remains financially stable and capable of repaying the loan. For SMBs, understanding and meeting the covenants set by lenders is critical to maintaining access to financing and avoiding penalties or complications during the loan period.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.