Quick overview

Covenants are contract provisions in business loan agreements that spell out what a borrower must do (affirmative or positive covenants), must not do (negative or restrictive covenants), and what financial metrics must be maintained (financial covenants). Properly drafted covenants balance lender protection with borrower flexibility. In my practice advising small and mid‑market businesses, I’ve seen well-negotiated covenants encourage good financial discipline and poorly drafted ones restrict growth or cause unintended defaults.

Why lenders include covenants

Lenders use covenants to:

  • Detect deterioration early by requiring periodic financial reporting.
  • Limit actions that would increase credit risk (e.g., taking on more senior debt).
  • Preserve collateral and protect repayment sources.

These provisions reduce information asymmetry between the borrower and lender and give the lender contractual remedies if risk increases (e.g., additional collateral, higher pricing, or loan acceleration). Regulatory and underwriting practices also make covenant frameworks a routine part of commercial lending.

(For background on how covenants appear in different loan types, see our sidebar: Loan Covenants Explained: Types and Consequences.)
Link: https://finhelp.io/glossary/loan-covenants-explained-types-and-consequences/

Common covenant types and examples

  • Affirmative (positive) covenants: Actions the borrower must take. Examples: maintain insurance, deliver audited financials within 120 days of year‑end, pay taxes when due.
  • Negative (restrictive) covenants: Actions the borrower must avoid. Examples: do not incur additional liens, do not pay dividends above a set threshold, do not sell material assets without lender consent.
  • Financial covenants: Numeric tests measured at agreed intervals. Examples: minimum interest coverage ratio, maximum debt‑to‑EBITDA, minimum net worth.
  • Reporting covenants: Regular delivery of financial statements, compliance certificates, tax returns, budgets, or forecasts.

Illustrative metrics: lenders commonly require an interest coverage ratio (EBITDA/interest expense), a fixed‑charge coverage ratio, a maximum leverage ratio (total debt/EBITDA), or a minimum current ratio. The precise formula, measurement period, and exclusions are negotiated and documented in the loan schedule.

How covenants are measured and enforced

Measurement frequency is usually monthly, quarterly, or annually and tied to the company’s reporting cadence. A covenant breach can be:

  • Technical (missed reporting)
  • Financial (ratio test failed)
  • Material (unauthorized transaction)

Remedies on breach typically include lender demand for cure, covenant waiver, fee/interest rate increases (step‑up), or acceleration of the loan. Lenders may also require additional collateral or guarantees. Many loan agreements include a cure period for certain breaches, or allow the borrower to request a waiver, but waivers may carry fees and tighter future terms. See our guide on Negotiating Waivers of Lender‑Covenant Defaults for practical negotiation steps.
Link: https://finhelp.io/glossary/negotiating-waivers-of-lender-covenant-defaults/

Practical borrower checklist for covenant negotiation

  1. Inventory proposed covenants: Ask for a covenant schedule in the term sheet and draft loan agreement.
  2. Understand definitions: Clarify formulae for EBITDA, consolidated vs. parent‑only, cash sweep triggers, and any carve‑outs. Precise definitions change covenant outcomes materially.
  3. Test the math: Run covenant scenarios with your accountant for down‑and‑up cases (slowdown, one‑time expenses, acquisitions).
  4. Negotiate ring‑fenced limits: Seek thresholds that reflect seasonality and short‑term volatility; ask for baskets (permitted amounts) for certain activities like acquisitions.
  5. Carve outs and grace periods: Obtain cure periods for reporting mistakes and limited waivers for capital expenditure spikes.
  6. Reporting cadence: Try to align reporting frequency with your internal close process to minimize ad hoc work and accounting expense.

In my work I routinely recommend building a covenant model into monthly reporting so management can see covenant headroom before measurement dates.

Common negotiation levers borrowers can use

  • Increase covenant thresholds or widen measurement periods.
  • Add EBITDA add‑backs for one‑time restructuring costs or non‑cash charges.
  • Introduce baskets that permit limited debt, dividends, or asset sales without prior consent.
  • Request materiality thresholds so small deviations won’t trigger technical default.

Smaller or early‑stage companies with limited track records will face tighter covenants; stronger borrowers can trade looser covenants for slightly higher pricing or additional collateral.

What happens if a covenant is breached

Breach consequences vary by lender and severity. Typical steps:
1) Lender notifies borrower and requests a compliance plan.
2) Parties negotiate waiver or amendment—often for a fee and tighter future covenants.
3) If unresolved, lender may accelerate the loan, demand repayment from guarantors, or pursue collateral remedies.

A common outcome is a short‑term waiver that includes additional reporting, a commitment fee, and an amendment to increase covenant cushions. Borrowers should proactively communicate and present a credible cure plan—lenders generally prefer remediation over foreclosure in commercial relationships.

Alternatives and remediation strategies

  • Covenant waiver: Formal lender consent that temporarily suspends compliance for a fee or additional security.
  • Amendment: Renegotiate covenant terms permanently (often harder and costlier).
  • Refinancing: Replace the facility with a new lender or structure if covenants become untenable—see our article on Refinancing Business Debt to Improve Covenant Compliance for timing and costs.
    Link: https://finhelp.io/glossary/refinancing-business-debt-to-improve-covenant-compliance/

Using a Covenant Compliance Certificate and internal controls

Many agreements require a periodic covenant compliance certificate signed by an officer or controller. Prepare these in advance by embedding covenant tests in accounting systems and including covenant tracking on monthly close checklists. Our covenant compliance certificate glossary entry explains what lenders expect and how to streamline the process.
Link: https://finhelp.io/glossary/covenant-compliance-certificate/

Real‑world examples (anonymized)

  • Case A (startup): A software startup agreed to a strict maximum leverage covenant. After a rapid hiring and marketing push, they briefly exceeded the covenant. They obtained a short waiver but paid a fee and accepted a lower leverage covenant thereafter—reducing flexibility for the next two years.
  • Case B (middle market): A manufacturing company negotiated an EBITDA add‑back for one‑time plant closure costs. The clearer definition prevented a technical default during a cyclical downturn, preserving the borrowing base and the firm’s lender relationships.

These examples illustrate how precise drafting and forward planning reduce disruption.

How covenants affect future financing and operations

Covenants signal credit quality to both current and prospective lenders. Persistent tight covenants or frequent waivers can limit future credit access and increase cost of capital. Conversely, compliance builds trust and often improves terms for follow‑on facilities.

Legal and tax considerations

Covenants are legal obligations—breaches can trigger enforcement rights and affect guarantors and related parties. Always have counsel review intercreditor arrangements and guaranty language. Tax treatment of covenant fees, waivers, or penalties can be situation‑specific; consult a CPA for implications. (See guidance at the U.S. Small Business Administration and Consumer Financial Protection Bureau for general lending practices.)

Professional tips I use with clients

  • Implement covenant forecasting as part of the monthly close.
  • Prioritize transparent communication with lenders—early dialogue often yields workable waivers.
  • Negotiate precise definitions in term sheets, not just high‑level ratios; small wording changes can materially affect compliance.
  • Build cushion into forecasts: plan to be comfortably above a covenant threshold, not just at it.

Resources and further reading

Disclaimer

This article provides educational information and examples based on common commercial lending practice and my professional experience. It is not legal, tax, or financial advice for specific situations. For advice tailored to your circumstances, consult a qualified attorney, CPA, or financial advisor.