Introduction

Loan covenants are one of the most consequential — and often misunderstood — parts of a venture debt agreement. They are the contract terms lenders use to protect capital when backing high-growth, often pre‑profit companies. While venture debt can be an efficient way to extend runway without immediate equity dilution, covenants shape how you can run the business while that loan is outstanding.

Why covenants matter for founders

Covenants balance lender risk and borrower freedom. For founders, the right covenant package can be benign; the wrong one can force unwanted behavior, block strategic transactions, or trigger expensive technical defaults. In my practice advising startups over the last decade, I’ve seen founders accept boilerplate covenants that later limited hiring, acquisitions, or follow‑on financings because they didn’t negotiate carve‑outs or cure periods up front.

Two high‑level covenant categories

  • Affirmative covenants: Actions you must take. Common items include delivering financial statements, maintaining insurance, paying taxes, and preserving corporate organization.
  • Negative covenants: Actions you must not take without lender consent. Examples include incurring additional debt, granting liens, selling material assets, or making large related‑party transactions.

A third practical category to watch: financial covenants — sometimes called maintenance covenants — which require the company to meet ongoing metrics (cash balance, liquidity ratios, minimum revenue, or maximum burn). Some venture debt uses incurrence covenants (you can take actions unless they would cause a covenant breach) while others use maintenance covenants that must be satisfied at periodic tests.

Common covenant terms you should expect

  • Reporting and information rights: Monthly or quarterly financials, board decks, cap table updates, and budget forecasts. These are standard and often non‑negotiable.
  • Cash or liquidity covenants: Minimum cash or liquidity thresholds to ensure runway. Lenders want to see a buffer that reduces default risk.
  • Debt and lien restrictions: Limits on taking additional debt, granting security interests, or subordinating the lender’s claim. These preserve the lender’s priority.
  • Negative pledge and asset sale restrictions: Preventing significant asset sales or licensing without consent.
  • Restricted payments and dividends: Prohibits distributions to shareholders until certain tests are met.
  • Change‑of‑control and material adverse change (MAC) clauses: Trigger events that can accelerate default or give lenders extra remedies.
  • Equity and cap table covenants: Limits on changes to shareholder rights, creation of new class of stock, or dilution mechanics without consent.
  • Personal guarantees and scope of recourse: For early ventures, some lenders require founder guarantees or security in key assets. (See related: Personal Guarantees in Loan Agreements: Risks and Alternatives.)

What a typical covenant package looks like in practice

Venture lenders vary, but a common setup is:

  • Affirmative covenants for reporting, insurance, tax payments.
  • Negative covenants restricting additional indebtedness, liens, and sale of core assets.
  • A cash‑based liquidity covenant (minimum cash or burn multiple) or a covenant tied to a covenant test date (quarterly).

Some lenders add bespoke covenants tied to the company’s unique risk profile: product return rates for hardware startups, regulatory maintenance for healthcare companies, or deferred revenue thresholds for SaaS businesses.

Examples and real scenarios

  • Example 1 (restrictive): A tech client with $5M venture debt could not complete a pre‑emptive strategic partnership because the loan’s change‑of‑control and asset sale covenants effectively required lender consent for the deal. They missed a growth opportunity while negotiating a costly waiver.

  • Example 2 (workable): A healthcare startup negotiated a minimum cash covenant with a modest cushion plus a quarterly cure window. When a temporary receivable delay threatened the covenant, they used the cure provision and avoided acceleration.

Remedies and consequences of breach

Breach can lead to:

  • Default and acceleration of the loan balance.
  • Higher interest (penalty rates) or default fees.
  • Enforcement of security and collateral (if the loan is secured).
  • Restrictions on the company’s bank accounts, payments, or distributions.
  • Forced waivers that cost the borrower in fees and stricter future conditions.

That said, lenders often prefer working through issues rather than immediate enforcement, because prolonged enforcement can destroy borrower value. Founders who communicate early and provide remediation plans usually secure waivers or amendments on reasonable terms.

Negotiation levers founders can use (practical tactics)

  • Replace maintenance covenants with incurrence covenants when possible. Maintenance covenants test performance periodically and can trip for temporary or timing issues; incurrence covenants only bite when you take a defined action (e.g., incur new debt).
  • Carve‑outs and baskets. Ask for carve‑outs for permitted activity (e.g., a limited amount of additional debt, customary equity issuances, or acquisitions under a dollar cap).
  • Grace and cure periods. Add short cure periods (30–90 days) and notice requirements so you can fix reporting or timing issues before a technical default.
  • Materiality and knowledge qualifiers. Limit negative covenants to material transactions and include knowledge-based qualifiers to avoid triggering on immaterial technical items.
  • Step‑downs and seasonal adjustments. For companies with seasonal rolls (retail, travel), negotiate seasonal tests or step‑down covenants that relax as milestones are met.
  • Remedies cap and waiver economics. Limit the lender’s remedies for certain breaches and negotiate pre‑agreed waiver fees so you know the cost of a cure in advance.
  • Use warrants, bloc‑equivalent pricing, or slightly higher interest in exchange for looser covenants. Lenders will accept economics tradeoffs when risk is priced correctly.

Drafting and due diligence tips

  • Read definitions closely. Many covenant traps live in the definition section: what counts as “debt,” “assets,” or a “material adverse change.”
  • Ensure reporting timelines match your internal cadence. If your controller prepares monthly statements, don’t accept weekly requirements you can’t sustain.
  • Limit lender covenants to information reasonably available to management rather than subjective standards tied to market conditions.
  • Get legal and financial counsel to model covenant stress tests. Run scenarios: miss a revenue target, delay a financing round, change cash collections. See how the covenant language behaves.

Monitoring compliance (operational checklist)

  • Build covenant testing into your monthly close checklist.
  • Maintain a covenant compliance binder with last delivered reports, trustee communications, and dated calculations.
  • Flag any non‑compliance to the board and counsel early; prompt disclosure improves the chance of a negotiated fix.

When to seek amendment vs. refinance

  • Amend when the breach is temporary or the lender is supportive and the cost of waivers is reasonable.
  • Refinance when the lender’s covenant package is structurally incompatible with future growth plans, or when market conditions allow better terms. Refinancing may increase cash costs in the short run but buy strategic flexibility.

Warrants and other economics

Venture lenders often compensate for looser covenants with non‑cash economics: warrants, equity kickers, or increased interest margins. Consider the full economic tradeoff: a slightly higher interest rate may be cheaper than a covenant that restricts an acquisition or hiring plan.

Checklist for founders before signing

  1. Identify all affirmative reporting obligations and ensure you can meet them without new hires.
  2. Map negative covenants to planned transactions in the next 12–24 months.
  3. Ask for specific carve‑outs for fundraising, acquisitions, and IP licensing.
  4. Negotiate cure periods and define notice procedures.
  5. Understand remedy mechanics: acceleration, enforcement, and waiver costs.
  6. Confirm whether founders’ personal guarantees are required and limit their scope and duration.

In my practice, the best outcomes come from candid conversations with lenders. Lenders want your company to succeed; most covenants are designed to reduce downside, not to micromanage growth. Offer transparency: present your 12–18 month plan, stress tests, and why certain covenants could impede execution. Where appropriate, pay a modest price—warrant coverage or slightly higher rate—to get the flexibility you need.

Related reading and internal resources

  • For how venture capital investors affect financing options, see our glossary on venture capital: “venture capital”.
  • To understand lender underwriting priorities, read: “What Lenders Look for in a Startup: Financials, Team, and Traction”.
  • For risks around founder guarantees that sometimes accompany covenant packages, see: “Personal Guarantees in Loan Agreements: Risks and Alternatives”.

(Internal links: venture capital — https://finhelp.io/glossary/venture-capital/; What Lenders Look for in a Startup — https://finhelp.io/glossary/what-lenders-look-for-in-a-startup-financials-team-and-traction/; Personal Guarantees in Loan Agreements — https://finhelp.io/glossary/personal-guarantees-in-loan-agreements-risks-and-alternatives/.)

Authoritative sources and further reading

  • U.S. Small Business Administration (guidance on business loans and loan documents): https://www.sba.gov
  • National Venture Capital Association (industry standards and resources): https://nvca.org

Professional disclaimer

This article is educational and reflects common market structures as of 2025 and my experience advising startups. It is not legal or financial advice for your specific transaction. Always consult your company counsel and financial advisor before signing or negotiating loan documents.