Most borrowers negotiate hard on rate and barely read the covenants. Then, two years later, a soft quarter trips a ratio nobody had looked at since closing, and the conversation with the lender changes permanently.
Covenants are the terms that govern the relationship after the money lands. They deserve more attention at signing than the spread does.
What is a loan covenant?
A loan covenant is a condition written into a credit agreement that the borrower must satisfy for the life of the facility. Some require you to do things, some prohibit you from doing things, and some require your financial performance to stay within defined limits. Breaching one is an event of default, regardless of whether you have missed a payment.
That last point is what surprises people. You can be current on every payment and still be in default.
What are the three types of loan covenants?
| Type | What it does | Example |
|---|---|---|
| Financial | Requires performance to stay within measured limits | Leverage must not exceed 3.50× EBITDA |
| Affirmative | Obliges you to do something | Deliver audited statements within 120 days |
| Negative | Prohibits you from doing something | No additional debt without lender consent |
Financial covenants get the attention, but affirmative covenants cause more day-to-day defaults, usually because someone missed a reporting deadline, not because the business deteriorated.
What is the difference between maintenance and incurrence covenants?
Maintenance covenants are tested on a schedule, usually quarterly, and must be satisfied continuously whether or not you do anything. Incurrence covenants are only tested when you take a specific action, like raising debt, making an acquisition, or paying a distribution.
The distinction matters enormously. A maintenance covenant means the lender re-underwrites you every quarter and a bad three months alone can trigger default. An incurrence covenant means you only face the test when you choose to act.
Middle-market bank and cash-flow facilities lean toward maintenance covenants. Asset-based facilities often carry lighter financial covenants, sometimes a single springing covenant that only applies when availability drops below a threshold. That difference is one of the real trade-offs between structures, covered in cash flow lending vs asset-based lending.
What are common financial covenant examples?
| Covenant | What it measures | Typical middle-market range |
|---|---|---|
| Total leverage ratio | Total debt ÷ EBITDA | Not to exceed 3.0–4.0× |
| Senior leverage ratio | Senior debt ÷ EBITDA | Tighter than total leverage |
| Fixed charge coverage (FCCR) | Cash available ÷ fixed charges | Not less than 1.10–1.25× |
| Debt service coverage (DSCR) | Cash flow ÷ debt service | Not less than 1.20–1.25× |
| Minimum EBITDA | Absolute floor on earnings | Set off the base-case model |
| Minimum liquidity | Cash plus availability | A fixed dollar floor |
| Capital expenditure limit | Annual capex ceiling | Set off the base-case model |
These are conventions, not rules. The level in your agreement is negotiated off your own projections.
The definitions matter more than the numbers
A leverage covenant of 3.50× sounds precise. It isn’t, until you read how the agreement defines the terms.
- Does EBITDA include addbacks, and are they capped? Which ones survive?
- Does debt include capital leases, seller notes, earnouts, or letters of credit?
- Does fixed charges capture maintenance capex, cash taxes, distributions, and scheduled amortisation?
Two agreements with identical 3.50× covenants can produce very different results on the same financials. Always model your ratios using your credit agreement’s own definitions rather than the textbook ones, coverage ratios walks through where those definitions bite.
How much headroom should you have at closing?
This is the calculation almost nobody runs, and it is the most useful one in this article.
Take a business with $2,000,000 of EBITDA, $6,300,000 of total debt, and a maximum leverage covenant of 3.50×:
| Line | Amount |
|---|---|
| Total debt | $6,300,000 |
| EBITDA | $2,000,000 |
| Current leverage | 3.15× |
| Covenant limit | 3.50× |
| EBITDA required to stay compliant ($6,300,000 ÷ 3.50) | $1,800,000 |
| Cushion before breach | $200,000 |
That is a 10% decline in EBITDA before the covenant trips. One lost customer, one bad quarter, one margin squeeze.
The business looks comfortably inside its covenant at 3.15× against a 3.50× limit. It isn’t. Run this calculation before you sign, and know the number, not the ratio, the dollar amount your earnings can fall before you are in default.
What happens if you breach a covenant?
A breach is an event of default, which gives the lender contractual remedies: default-rate interest, suspension of further advances, new reserves or tightened advance rates, a required financial consultant, or acceleration of the entire balance.
In practice most first breaches end in a waiver, for a fee, and often with repricing, tighter covenants going forward, or additional reporting. The facility usually survives. The negotiating position does not: from that point the lender holds leverage it did not hold the day before. That dynamic is covered in what private capital oversight actually looks like.
The practical rule: tell the lender before they find it. A borrower who calls in advance with a forecast and a plan is treated very differently from one whose breach surfaces in a compliance certificate.
What is a cure right?
A cure right lets you fix a breach within a defined window rather than defaulting immediately. An equity cure permits an injection of new equity to be counted toward EBITDA or applied to debt so the ratio is retested and satisfied.
Equity cures are usually limited, a maximum number of uses over the life of the facility, and often no two consecutive quarters. Whether you have one, and how tightly it is capped, frequently matters more than the covenant level itself. Check it in the term sheet before you sign, alongside every other provision that decides what happens when things go wrong, see term sheet anatomy.
How do you negotiate covenants?
- Set levels off a realistic case, not the optimistic one. Covenants built on a plan you have to hit perfectly are covenants you will breach.
- Ask for headroom of 15–25% against your base case, and know the dollar figure it represents.
- Negotiate definitions, not just levels. Getting an addback recognised in the EBITDA definition can be worth more than a quarter-turn of leverage.
- Push for cure rights, and for a reasonable number of uses.
- Match reporting deadlines to reality. If you cannot close books in 30 days, do not agree to 30 days.
- Prefer fewer, well-understood covenants over many marginal ones. Every additional test is another way to default.
Run your own file first
Want to know how much headroom your covenants would actually leave you? Run the assessment or send us your financials and any term sheet and we’ll show you where the tripwires sit.
Educational only. Nothing here is an offer of credit, a commitment to lend, or legal advice. Covenant types, levels, and definitions vary by lender and agreement; the figures above are illustrative.