Overview

Covenants are routine parts of commercial loan agreements. Lenders use them to monitor a borrower’s financial health and limit actions that could increase credit risk. Borrowers must understand covenant mechanics because breaches can trigger penalties, demand for immediate repayment (acceleration), or renegotiation.

Types of covenants

  • Financial (maintenance) covenants: Require ongoing metrics such as debt-service coverage ratio (DSCR), interest coverage ratio, leverage (debt/EBITDA) or minimum net worth. Lenders commonly set DSCR requirements (often around 1.2–1.5 for cash-flow loans) but thresholds vary by lender and industry. (See Investopedia on covenants.)
  • Incurrence covenants: Limit actions that can be taken when the borrower takes on new debt or completes transactions (e.g., additional borrowing, paying dividends).
  • Positive (affirmative) covenants: Require actions such as delivering audited financials, maintaining insurance, or paying taxes on time.
  • Negative covenants: Prohibit actions like selling major assets, changing ownership (change of control), or granting liens without lender consent.
  • Reporting covenants: Set cadence and format for financial reporting, audits, or covenant certificates.

Common triggers that cause covenant enforcement

  • Missed payment: Late principal or interest payments often trigger default provisions before other covenant tests.
  • Financial ratio breaches: Falling below a DSCR or exceeding a leverage cap typically generates a covenant breach.
  • Cross-defaults: A default on another agreement can trigger a default under this loan (common in syndicated facilities).
  • Material adverse change (MAC) or change-of-control events: Significant deterioration in business or ownership shifts can activate lender rights.

Real-world examples and practice insight

In my practice working with mid‑market borrowers, I’ve seen seasonal businesses lag on cash-balance covenants in Q1. Prompt, transparent communication with the lender and a short-term covenant waiver often avoided acceleration. For growth-stage companies, incurrence covenants that block new financings can unintentionally limit strategic hires or acquisitions—make sure covenants align with expected growth plans.

What happens after a breach

Lenders typically have a menu of remedies: negotiate a waiver or amendment (most common), impose default interest or fees, require additional collateral, or call the loan (acceleration). Many lenders prefer a controlled workout or covenant amendment to preserve value rather than immediate foreclosure.

How borrowers reduce covenant risk

  1. Negotiate realistic tests up front: Use cash-flow seasonality, forecast scenarios, and industry comparables when proposing covenant levels. See our guide on Negotiating Loan Covenants: What Small Businesses Can Ask For.
  2. Build reporting routines: Standardize monthly covenant calculations and run sensitivity models so you spot breaches early.
  3. Keep communication open: Early notices and covenant breach discussions often lead to waivers or amendments rather than acceleration. For signs to watch, read Early Warning Signs: Loan Covenant Triggers and What To Do.

Negotiation levers borrowers can ask for

  • Grace periods, cure periods, or step-in waivers for short-term breaches.
  • Basket exceptions in incurrence covenants for modest additional indebtedness or capital expenditures.
  • Materiality thresholds or measurement adjustments to prevent minor book-keeping fluctuations from triggering breaches.

Common mistakes and misconceptions

  • Treating covenants as boilerplate: Terms vary widely—don’t assume a “standard” covenant package.
  • Waiting until a breach: Lenders are more likely to cooperate when informed early.
  • Overlooking definitions: How EBITDA, cash, or covenant test dates are defined can change outcomes—review definitions carefully.

FAQ (short answers)

  • What if I breach a covenant? Remedies range from fees and waivers to loan acceleration; immediate lender communication is critical.
  • Can covenants be changed? Yes — through amendment or waiver, typically for a fee or revised pricing and conditions.
  • Do small loans have covenants? Yes; lenders use covenants to allocate risk regardless of loan size.

Authoritative sources and further reading

Internal guides

Professional disclaimer

This article is educational and not personal legal, tax or financial advice. For decisions about loan terms or covenant negotiation, consult your attorney and financial advisor.

(Edited for clarity and accuracy as of 2025.)