Overview

Loan covenants are written promises in credit agreements that protect lenders by limiting borrower behavior or requiring ongoing financial performance. Two of the most important covenant families are maintenance covenants and incurrence covenants. Both control risk, but they operate very differently and have distinct implications for operations, financing flexibility, and default risk.

In my practice advising middle-market companies and startups over the past 15 years, I’ve seen both covenant types used strategically. Properly negotiated covenants can preserve borrowing capacity while giving lenders comfort; poorly drafted or misunderstood covenants can block growth or trigger technical defaults.

Why the distinction matters

  • Timing of tests: Maintenance covenants are tested on a regular schedule (monthly, quarterly, or annually). Incurrence covenants are measured only when the borrower wants to do something the agreement flags as a trigger (take on new debt, make an acquisition, change capital structure).
  • Predictability: Maintenance covenants require ongoing compliance and therefore demand continuous monitoring of performance. Incurrence covenants let a borrower operate freely until a discrete action would force a test.
  • Flexibility vs protection: Lenders use maintenance covenants to detect deterioration early. Incurrence covenants give borrowers more day-to-day freedom but limit specific strategic moves unless tests pass.

Common examples and metrics

Maintenance covenant examples

  • Debt Service Coverage Ratio (DSCR) — minimum maintained each reporting period, for example > 1.25.
  • Interest Coverage Ratio (EBIT or EBITDA to interest expense) — often required every quarter.
  • Leverage ratios (Total Debt / EBITDA) — capped at a maximum on ongoing basis.
  • Minimum liquidity or cash balance — required at all times above a specified floor.

Incurrence covenant examples

  • New debt incurrence cap — borrower may not incur additional debt if Total Debt/EBITDA would exceed a set threshold at the time of incurrence.
  • Restricted M&A or asset sale clauses — a borrower can’t complete an acquisition unless pro forma leverage or interest coverage tests are satisfied.
  • Restricted payments (dividends, share buybacks) that are allowed only if certain balance-sheet tests are met at the time of payment.

How lenders use each type

  • Maintenance covenants: Lenders who want early detection of credit deterioration or who finance cyclical businesses often insist on maintenance tests. Banks and institutional lenders that monitor covenant ratios quarterly use them to compel corrective action before liquidity runs out.
  • Incurrence covenants: These are more common in acquisition financings, mezzanine or unitranche facilities, and venture or growth-stage financings where lenders want to limit specific actions (e.g., new debt, material transactions) without policing day-to-day operations.

Practical differences: a simple scenario

  • Maintenance covenant scenario: A retailer must keep a quarterly current ratio above 1.0. A seasonal sales slump causes the ratio to dip below 1.0 and triggers an event of default. The lender can demand cure, request additional collateral, or negotiate a waiver.
  • Incurrence covenant scenario: The same retailer can operate with a current ratio below 1.0 but may be prohibited from acquiring another chain unless post-transaction leverage would be below 2.5x. The covenant blocks the M&A unless the borrower reduces leverage or obtains a waiver.

Negotiation levers borrowers can use

  1. Define clear calculation mechanics. Lenders and borrowers often disagree on what counts as EBITDA, cash, or debt. Specify add-backs, timing, and pro forma adjustments. Clear definitions reduce disputes.
  2. Add baskets and cures. Baskets allow limited actions (e.g., $X of additional debt) without triggering tests. Cure provisions let borrowers fix a shortfall within a short, defined period.
  3. Use springing incurrence covenants carefully. A “springing” covenant becomes a maintenance covenant only after a trigger (e.g., if senior debt rises above a threshold). Negotiate thresholds and timelines.
  4. Limit look-back and pro forma adjustments. Insist that tests examine only actual and reasonably projected financials for a short, defined period.
  5. Negotiate reporting frequency. If a lender insists on monthly tests that strain finance resources, seek quarterly reporting instead.

Monitoring and compliance best practices

  • Set up automated covenant testing in your accounting system. Manual checks increase error risk.
  • Maintain a covenant calendar aligned to reporting dates, notice periods, and waiver windows.
  • Run pro forma tests before any material transaction—don’t wait for the lender to raise an issue.
  • Keep clear audit trails for calculation choices and one-off adjustments.

In my experience, the single biggest operational improvement for borrowers is automating the covenant calculation and alerting management a month ahead of the reporting date. That lead time creates options.

Real-world examples

Case 1 — Maintenance covenant breach

A mid-sized manufacturer had a quarterly leverage covenant (Total Debt/EBITDA < 3.5). After a year of rising input costs and delayed receivables, EBITDA fell and the ratio briefly went to 3.7. The lender called the breach, required monthly covenant reporting, and negotiated a short-term fee and amortization increase. The borrower avoided default by agreeing to a temporary covenant reset and providing additional collateral.

Case 2 — Incurrence covenant blocking growth

A SaaS startup wanted to raise a bridge loan to accelerate sales hiring. Its existing term loan had an incurrence covenant preventing any new senior debt if pro forma leverage exceeded 2.0x. Because the bridge would push leverage to 2.3x, the lender refused to allow the new loan unless the borrower obtained a waiver or prepaid part of the existing debt. The company restructured its plan and used equity bridge financing instead.

Common mistakes borrowers make

  • Not reading the covenant definitions closely. The devil is in the definitions (what counts as debt, which subsidiaries are included, which adjustments are allowed).
  • Treating incurrence covenants as harmless. They can silently block financing, acquisitions, or dividend plans.
  • Missing timing and notice windows for waivers. When you discover a potential breach, early communication is essential.
  • Failing to model covenants under stress scenarios. Scenario planning (best, base, worst) is critical for growth planning.

Interlinking resources (FinHelp.io)

Authoritative context and sources

  • The U.S. Securities and Exchange Commission explains how covenants affect credit agreements and investor disclosures (U.S. Securities and Exchange Commission).
  • Financial accounting and covenant calculation conventions are guided by industry practice and standards from bodies like the Financial Accounting Standards Board (FASB) and professional guidance from the AICPA.
  • Consumer-facing resources on borrowing and credit practices are available at ConsumerFinance.gov for comparisons between commercial and consumer loan practices.

(These sources reflect industry practice and regulatory perspectives current through 2025.)

Practical checklist before signing

  • Confirm the calculation definitions for each covenant item.
  • Model at least three scenarios (normal, down 15%, down 30%) and their covenant outcomes over 18–24 months.
  • Ask for baskets (e.g., $X of permitted debt, permitted acquisitions up to $Y) and short cure periods.
  • Negotiate reporting frequency and audit rights to reasonable levels that your finance team can sustain.
  • Secure waiver pathways and understand the lender’s remedies and notice requirements.

Professional disclaimer

This article is educational and does not constitute legal, tax, or investment advice. Covenant language and lender remedies vary. Consult your attorney, CPA, or a qualified finance professional to review specific loan documents and negotiations.

Closing note

Maintenance and incurrence covenants are tools lenders use to manage credit risk. For borrowers, the key is clarity: know the exact tests, automate monitoring, and build covenant outcomes into your strategic planning. With clear definitions and a negotiation plan, covenants can be managed rather than feared.