Why covenants matter for growth-stage startups

Loan covenants are not just legal boilerplate. They directly affect a founder’s ability to execute growth plans, raise follow-on capital, and manage cash flow. Lenders use covenants to limit downside while startups trade some flexibility for access to capital. In my practice advising growth-stage companies, founders who treat covenants as operational constraints—rather than legal footnotes—avoid most surprises.

Authoritative guidance from the U.S. Small Business Administration and industry sources show that covenants vary widely by lender, loan type, and company stage (U.S. Small Business Administration; Investopedia). Venture debt and bank term loans commonly include different mixes of covenants and enforcement mechanisms.

Common covenant types and plain-language meanings

  • Affirmative covenants (aka positive covenants): actions the borrower must take. Examples: deliver monthly financial statements, maintain insurance, file taxes on time, or maintain a minimum cash balance.

  • Negative covenants: actions the borrower must avoid. Examples: don’t take additional debt without consent, don’t pay dividends above a cap, don’t sell key assets.

  • Financial covenants: numeric tests measured regularly. Typical tests for startups include:

  • Minimum liquidity / cash covenant: maintain a set cash balance or days cash on hand.

  • Debt service coverage ratio (DSCR): operating cash flow divided by required debt payments — measures ability to service debt.

  • Interest coverage ratio (EBITDA-based): EBITDA divided by interest expense.

  • Leverage ratio (Total Debt / Adjusted EBITDA): limits how much debt can sit on the balance sheet relative to earnings.

  • Fixed charge coverage ratio (FCCR): EBITDA plus fixed charges divided by fixed charges including scheduled debt service.

  • Maintenance vs. incurrence covenants:

  • Maintenance covenants require you to be at or above (or below) a metric on an ongoing basis (e.g., every quarter).

  • Incurrence covenants only trigger when you want to take a specific action (e.g., incur new debt or make an acquisition).

For a deeper look at maintenance vs incurrence covenants, see our guide on Understanding Maintenance vs Incurrence Covenants for Loans.

Real-world examples and simple calculations

Example 1 — Interest Coverage Ratio

  • Covenant: Interest Coverage Ratio >= 3.0x measured quarterly.
  • Calculation: Trailing 12-month EBITDA = $3.0M; annual interest = $1.0M; ratio = 3.0x -> covenant met.

Example 2 — Leverage ratio breach

  • Covenant: Net Debt / Adjusted EBITDA <= 3.0x.
  • Company has $9M net debt and $2.5M adjusted EBITDA -> leverage = 3.6x -> breach.

Example 3 — Minimum cash covenant

  • Covenant: minimum cash $500k at all times.
  • Unexpected payroll and vendor payments reduce cash to $350k -> default unless a waiver is obtained or a covenant cure applies.

These calculations can be tricky when loan agreements define EBITDA, adjustments, and debt differently. In my experience, small definition differences or timing mismatches in lease accounting and working capital can flip a covenant outcome.

What lenders typically expect from growth-stage startups

Lenders will generally seek:

  • Regular, timely financial reporting (monthly or quarterly P&L, balance sheet, cash flow)
  • A covenant compliance certificate signed by management
  • Board or management presentations when requested
  • Evidence of insurance, legal compliance, and collateral maintenance

Some lenders also require reserve structures like a Debt Service Reserve Account (DSRA) or sinking fund. Read more on cash cushions and reserve accounts in our article on Sinking Funds and DSRA: Cash Management for Loan Covenants.

Negotiation levers founders can use

  • Convert maintenance covenants to incurrence covenants where possible. Lenders prefer maintenance tests, but incurrence covenants give startups greater operational flexibility.
  • Add cure periods and grace windows. Request a defined cure period (e.g., 30–60 days) before a technical default becomes an event of default.
  • Define metrics clearly. Push back on ambiguous definitions for EBITDA, net debt, or revenue recognition.
  • Include springing covenants tied to specified thresholds (e.g., step-up covenants only trigger above a defined leverage level).
  • Negotiate reporting cadence and waive certain monthly deliverables in favor of quarterly reporting.
  • Pay for flexibility when needed. Lenders may accept looser covenants for a higher margin, additional collateral, or a prepayment facility.

For tactical negotiation tips tailored to bank deals, see Best Practices for Negotiating Loan Covenants with Banks.

In venture debt deals expect additional features such as warrants, payment-in-kind (PIK) interest, and tighter covenants early in the loan life. See Loan Covenants in Venture Debt: What Founders Should Expect.

Monitoring and governance: build covenant compliance into operations

  • Designate a covenant owner (CFO/finance lead) responsible for monthly calculation and certification.
  • Build an automated covenant dashboard in your accounting system or BI tool.
  • Stress-test forecasts — run covenant scenarios on planned hires, marketing spend, or M&A decisions.
  • Document assumptions used to calculate metrics and keep backup data for audits by lenders.

Practical checklist for each reporting period:

  1. Recalculate every covenant using the loan agreement definitions.
  2. Reconcile timing differences (accrual vs. cash).
  3. Prepare compliance certificate and supporting workpapers.
  4. Discuss variances with the lender before a potential breach.

Remedies, waivers, and the cost of breaches

Consequences of a covenant breach can include:

  • Increased interest margin or default interest rate
  • Additional collateral requirements or tightened covenants
  • Acceleration of the loan (rare but possible)
  • Restrictive cross-defaults with other lenders or investors

Waiver process: typically you must disclose the breach, request a waiver or amendment, pay a fee, and negotiate any new conditions. Lenders may require board or shareholder consents depending on the severity.

In many cases lenders prefer a negotiated cure because drawing collateral or accelerating loans can be costly and time-consuming. Early communication often reduces the cost of resolving an issue.

Practical strategies founders should adopt immediately

  • Underwrite with cushion. Target covenant levels at least 10–20% stronger than the covenant floor in forecasts.
  • Automate covenant calculations monthly and keep a 3–6 month rolling forecast showing covenant paths.
  • Keep an open line with lenders. Share monthly or quarterly dashboards proactively when you expect volatility.
  • Build cap table and corporate structure clarity to avoid inadvertent change-of-control or ownership covenants.
  • Lock in definitions during negotiation to avoid surprises—especially EBITDA, working capital, and lease treatments.

In my consulting practice I’ve seen startups that avoided defaults simply by asking for a short waiver and agreeing to a modest fee while they executed a revenue catch-up. Founders who wait until a covenant breach is public typically lose negotiating leverage.

When to involve legal and financial advisors

  • Always have counsel review loan documents before signing. Lawyers spot traps in covenant definitions, cross-default language, and acceleration clauses.
  • Hire a finance advisor or fractional CFO if your team lacks experience with covenant calculations and lender negotiations.
  • Consider tax and accounting input when covenant calculations depend on non-GAAP adjustments or lease accounting treatments.

Sources and further reading

  • U.S. Small Business Administration — loan and financing resources (U.S. Small Business Administration)
  • Investopedia — loan covenants overview (Investopedia)
  • Federal Reserve — commercial loan contracting and credit risk literature (Federal Reserve)

Professional disclaimer

This article is educational and does not constitute individualized legal, tax, or financial advice. Loan agreements are binding legal contracts; consult qualified legal counsel and a finance professional before signing or amending loan documents.