Background

In my 15 years advising small businesses on financing, I’ve seen loan covenants transform from a lender-only control into a practical tool when negotiated correctly. Lenders use covenants to limit downside; borrowers can use negotiation to keep necessary flexibility while giving lenders confidence.

How covenants work (quick primer)

  • Affirmative covenants: require actions such as providing financial statements or maintaining insurance.
  • Negative covenants: restrict actions like taking on more debt, selling key assets, or paying dividends.
  • Financial covenants: numeric tests (e.g., debt-service coverage ratio, leverage ratio) measured monthly, quarterly, or annually.

Common negotiation asks small businesses should consider

  1. Measurement and timing
  • Ask for quarterly testing rather than monthly or for tests measured on a trailing 12-month basis (LTM) instead of point-in-time. This smooths temporary seasonal swings.
  • Request a materiality threshold (de minimis) so small one-off events don’t trigger a breach.
  1. Definitions and calculation clarity
  • Define key terms (EBITDA, net income, consolidated vs. borrower-only) to avoid surprise adjustments.
  • Ask for specific permissible add‑backs (restructuring costs, one-time capital expenditures) and a cap on total add‑backs.
  1. More forgiving covenant levels or baskets
  • Negotiate lower ratio hurdles (raise minimum DSCR or lower maximum leverage) or carve out a covenant holiday for initial months after closing.
  • Ask for “baskets” that allow a set amount of additional borrowing, acquisitions, or restricted payments before lender consent is required.
  1. Cure, waiver and remedy provisions
  • Secure a defined cure period (e.g., 30–90 days) or the right to request a one-time waiver without immediate acceleration.
  • Negotiate reasonable fees for amendments rather than punitive penalties.
  1. Scope and collateral limits
  • Limit guarantees to specific owners or reduce personal guarantees where possible. Ask for non-recourse treatment on certain assets if feasible.
  • Carve out operating accounts or critical equipment from permitted liens.
  1. Reporting and administrative relief
  • Move from audited statements to reviewed or internally compiled statements for smaller loans, or reduce reporting frequency after a covenant-free period.
  1. Compensating provisions
  • If the lender resists loosening covenants, offer compensating items: a modest interest-rate premium, a prepayment fee, or additional collateral that’s less critical to operations.

Practical negotiation steps (what to bring to the table)

  1. Prepare a covenant-focused financing package: historic financials, 12‑ to 24‑month cash‑flow projections, stress tests, and a use-of-proceeds memo.
  2. Run stress scenarios showing covenant performance under downside cases—this builds credibility and highlights which covenant terms are realistic.
  3. Prioritize asks: identify 2–3 must-change items (for example, DSCR level, cure period, or a permitted‑liens carve‑out) and secondary asks if the lender is willing.
  4. Use relationship capital—a demonstrated banking history or alternate compensating terms can make lenders more flexible.

Real-world examples

  • A small manufacturer negotiated quarterly testing and a 60‑day cure period for a DSCR covenant; this avoided a technical breach during seasonal revenue swings and let them complete a scheduled equipment purchase.
  • A tech startup obtained an equity‑cure right (allowing a shareholder injection to fix a breach) in exchange for a small uptick in pricing.

Who is affected and eligibility

Any small business taking debt—SBA loans, bank term loans, lines of credit, or venture debt—can face covenants. Lenders will push more restrictive terms for newer firms, weaker financial histories, or higher-risk industries; stronger borrowers have more leverage.

Common mistakes to avoid

  • Accepting boilerplate language without definitions.
  • Failing to model covenant outcomes under stress.
  • Not getting a lawyer or experienced finance advisor to review cure language, acceleration triggers, and waiver mechanics.

Quick negotiation scripts (concise asks)

  • “Can we change covenant testing to quarterly with a 60‑day cure period to avoid seasonal technical breaches?”
  • “Will the bank allow an EBITDA add‑back for one‑time restructuring costs, capped at $X?”
  • “Can we carve out the new equipment financing from the borrowing base and allow a $50k basket for capital expenditures?”

What happens if you breach a covenant

Consequences vary: lender notice and cure opportunity, waiver with fee, higher pricing, or in severe cases acceleration of the loan. Many lenders prefer a negotiated cure rather than immediate remedies—so early communication matters. See our guide on early-warning signs and actions here: Early Warning Signs: Loan Covenant Triggers and What To Do.

Further reading and internal resources

Authoritative sources

  • U.S. Small Business Administration (SBA): about SBA loan programs and lender requirements (sba.gov)
  • Consumer Financial Protection Bureau (CFPB): small‑business lending practices (consumerfinance.gov)

Professional disclaimer

This article is educational and not legal or financial advice. For deal-specific wording, priority of liens, or guaranty negotiation, consult your attorney or a qualified commercial finance advisor.

Notes on sourcing

Advice here reflects best practices current through 2025 and my experience advising small businesses on loan structuring and covenant negotiations.