Author credentials
I’m a CPA and CFP® with 15+ years advising small business owners on lending, cash-flow planning, and loan negotiations. I’ve reviewed hundreds of term sheets and loan agreements, negotiated covenant relief, and helped clients plan covenant-compliance workflows. The examples and tactics below come from that hands-on experience.
Why loan covenants matter (short primer)
Lenders use covenants to monitor borrower risk and create early-warning triggers. For small businesses, covenants influence how you manage cash, invest in growth, and report financials. A well-crafted covenant package balances lender protections with enough flexibility for the business to operate and grow.
Authoritative context: regulators and guidance
- Consumer Financial Protection Bureau (CFPB) explains borrower protections and transparency expectations for lending relationships (consumerfinance.gov).
- The U.S. Small Business Administration (SBA) and bank lending practices commonly rely on covenants for government-backed and conventional loans.
Common types of loan covenants
Loan covenants usually fall into three broad categories:
- Affirmative covenants (what you must do): provide quarterly financial statements, maintain insurance, pay taxes, and comply with laws.
- Negative covenants (what you must not do): restrict additional debt, liens, asset sales, or distributions to owners without lender consent.
- Financial covenants (tests you must meet): maintenance covenants like minimum current ratio, minimum liquidity, minimum tangible net worth, maximum leverage (debt-to-equity), minimum interest coverage ratio, or minimum debt-service coverage ratio (DSCR).
Note: Financial covenants can be “maintenance” (measured regularly, e.g., quarterly) or “incurrence” (only tested when you take a specified action such as borrowing more).
Relevant link: lenders frequently monitor DSCR; see how DSCR affects approval and covenant design in our article on how DSCR affects commercial loan approval.
(Anchor: How Debt-Service Coverage Ratio (DSCR) Affects Commercial Loan Approval) — https://finhelp.io/glossary/how-debt-service-coverage-ratio-dscr-affects-commercial-loan-approval/
Typical covenant language and red flags to watch for
- Measurement period: Is the covenant tested monthly, quarterly, or annually? More frequent tests increase monitoring burden.
- Definitions: Watch how the loan defines EBITDA, cash, or “net income.” Some lenders add add-backs or adjustments that materially change the metric.
- Cure periods and notice: Does the lender provide a cure or grace period for breaches, or can they accelerate the loan immediately?
- Cross-default and cross-collateralization: A breach on one loan could trigger default on others.
Red flags: vague definitions (undefined “good financial condition”), unlimited discretion (lender can declare default at will), or overly strict ratios with no seasonal flexibility.
What happens if you breach a covenant
Consequences range by severity:
- Technical default with opportunity to cure (common for minor breaches).
- Penalties: higher interest margin, fees, or amended terms.
- Waivers or amendments: lenders often agree to temporary relief if you negotiate proactively.
- Acceleration: in severe cases, the lender can demand immediate repayment or foreclose on collateral.
Real-world resource: read our deeper guide on what triggers a loan covenant breach and the typical next steps for borrowers.
(Anchor: What Triggers a Loan Covenant Breach and What Happens Next) — https://finhelp.io/glossary/what-triggers-a-loan-covenant-breach-and-what-happens-next/
Practical negotiation and compliance strategies
1) Prepare a covenant model before you sign
- Project your financials under base, upside, and downside scenarios for the covenant metrics lenders will test (current ratio, DSCR, leverage). Show lenders you’ve stress-tested your plan.
2) Ask for realistic definitions and useful carve-outs
- Limit adjustments to EBITDA; avoid unlimited add-backs. Ask for seasonal adjustments if your business has cycles.
- Seek an agreed-upon definition of cash and working capital to avoid ambiguity.
3) Favor incurrence covenants for growth activities
- Where possible, request incurrence-only covenants for new borrowing or major asset purchases. This gives you flexibility until you actually take the action.
4) Negotiate cure periods and waiver language
- A 30–90 day cure period for technical breaches is common and gives you time to remediate without loan acceleration.
5) Build contractual flexibility: covenant baskets and thresholds
- Ask for baskets (e.g., the business can still make distributions up to $X) or a buffer (e.g., covenant must be 10% above the stated trigger) to reduce the chance of inadvertent breach.
6) Use covenant relief strategically
- If you expect a short-term liquidity issue, discuss temporary covenant waivers or amendments early. Lenders often prefer negotiated relief to pushing a borrower into default that could reduce recovery value.
Monitoring checklist for ongoing compliance
- Create a covenant calendar listing test dates, required deliverables, and responsible team members.
- Automate financial reporting where possible (accounting software exports, dashboarding for KPI tracking).
- Reconcile lender definitions quarterly (e.g., confirm how they calculate EBITDA) and store documentation of add-backs and adjustments.
- Maintain an approved variation log: any consent, waiver, or amendment should be documented and retained with the loan file.
Cost vs. benefit: when covenants are reasonable
Covenants can be a net positive when they:
- Force disciplined financial reporting and cash management.
- Lower lenders’ rates (stronger covenants can produce better pricing) because the lender’s risk is reduced.
However, covenants become harmful when they are so restrictive they block essential investments, force unnecessary equity contributions, or create operational micromanagement.
Example covenant scenarios (practical illustrations)
Scenario A — Growth-stage manufacturer
- Covenant: minimum current ratio of 1.2, quarterly test.
- Problem: seasonal inventory buildup lowers the ratio in Q4. Solution: negotiate a seasonal adjustment or include inventory treatment that counts certain raw materials differently.
Scenario B — Service business seeking expansion
- Covenant: limit on capital expenditures above $50,000 per year.
- Problem: a needed $80,000 equipment purchase. Solution: ask for a carve-out for replacement equipment or cap additional expenditures tied to new revenue milestones.
Scenario C — Small retailer with one bank loan
- Covenant breach occurs due to delayed receivables. Outcome: lender issues a technical default, but provides a 60-day waiver after lender review and a plan to collect receivables.
Who is most affected
- Businesses taking significant debt (term loans, asset-based loans, commercial mortgage loans) will see covenants most often.
- Early-stage startups may face milestone-based covenants tied to revenue or fundraising events.
- Community banks and nonbank lenders differ: community banks often use more traditional financial covenants; alternative lenders may impose stricter operational limits.
Mistakes to avoid
- Signing the loan without reading covenant definitions and measurement frequency.
- Relying solely on verbal assurances—get all agreed changes in writing.
- Failing to model how growth investments affect covenant metrics.
- Not communicating early with lenders when a covenant slippage is expected.
Negotiation checklist to bring to term-sheet meetings
- Request full covenant wording early.
- Bring projected financial statements and covenant stress tests.
- Ask for monthly vs. quarterly testing tradeoffs and aim for quarterly where possible.
- Seek clear definitions for key terms (EBITDA, cash, revenue recognition).
- Propose a 30–90 day cure period and one-time waiver options for extraordinary events.
When to get professional help
- Complex covenant packages or cross-default language require legal review by a lawyer experienced in commercial lending.
- Financial covenant modeling and negotiating add-backs are best handled with a CPA or CFO advisor.
- If you face a breach, consult your legal and financial advisors before signing any waiver or amendment.
Quick FAQs (short answers)
- Can covenants be renegotiated? Yes—lenders often renegotiate if you present a credible remediation plan.
- Do covenants apply to SBA loans? Many SBA 7(a) and 504 loans include covenants; terms vary by lender and guaranty structure.
- Will covenants hurt my ability to raise equity? Strict covenants can complicate new equity raises; communicate with potential investors about existing commitments.
Final takeaway
Loan covenants are normal and often reasonable tools for lenders, but they are negotiable and can materially affect operations and growth plans. The best outcome is a covenant package that gives lenders comfort while preserving the business’s ability to run and invest. Prepare in advance, model covenant outcomes, and seek professional help if terms are complex or restrictive.
Professional disclaimer
This article is educational and not individualized financial, legal, or tax advice. Consult a licensed attorney, CPA, or financial advisor for guidance tailored to your business and loan documents.
Sources and recommended reading
- Consumer Financial Protection Bureau (CFPB): Borrower protections and lender transparency guidance (consumerfinance.gov).
- U.S. Small Business Administration: Lender and borrower resources for SBA loans (sba.gov).
- For more on covenant breaches and next steps, see our glossary piece: “What Triggers a Loan Covenant Breach and What Happens Next.”
Related FinHelp articles
- How Debt-Service Coverage Ratio (DSCR) Affects Commercial Loan Approval: https://finhelp.io/glossary/how-debt-service-coverage-ratio-dscr-affects-commercial-loan-approval/
- What Triggers a Loan Covenant Breach and What Happens Next: https://finhelp.io/glossary/what-triggers-a-loan-covenant-breach-and-what-happens-next/
(Last reviewed: 2025)
