Keelpark Capital Group, a small-business funding broker in Jackson, Tennessee, explains business loan covenants: affirmative covenants (things you must do), negative covenants (things you must not do without consent) and financial covenants (ratios you must maintain), with examples, what a covenant violation can mean, and the questions to ask a lending partner before signing.
| What a covenant is | A promise in the loan agreement beyond repayment |
|---|---|
| Three main types | Affirmative, negative and financial |
| Where they appear | Most often in term loans and larger lines of credit |
| If one is broken | The agreement sets out the lender's options; ask an attorney |
| Who sets them | The lending partner, not Keelpark Capital Group |
What is a loan covenant?
When a lender makes a loan, it relies on the business staying roughly as it was when the loan was approved. Covenants are how the agreement protects that assumption. They let the lender see problems early and give it a say before the business makes certain big changes. Covenants appear most often in term loans and larger lines of credit; short, small facilities may have few or none.
Affirmative covenants: things you must do
- Send financial statements or tax returns by set dates
- Keep insurance on the business and on any collateral
- Keep the business registered and in good standing, and pay taxes when due
- Maintain business accounts with the lender, in some agreements
- Tell the lender promptly about lawsuits, major losses or a change in management
Negative covenants: things you must not do without consent
- Take on additional debt above a set limit
- Grant liens on assets to another lender
- Sell major assets or the business itself, or change ownership
- Pay distributions or owner draws above a limit in some agreements
- Merge, change the type of business, or move collateral out of state
Negative covenants are the ones most likely to collide with ordinary plans. If you expect to buy equipment on separate financing next year, or add a partner, raise it before signing.
Financial covenants: numbers you must keep in range
Financial covenants set a measure the business must stay above or below, tested at set intervals. Common examples are a minimum debt service coverage ratio (how many times operating cash flow covers loan payments), a maximum ratio of debt to earnings or to net worth, and a minimum cash or working capital balance. The lender chooses the measure, the level and the testing schedule; ask exactly how each figure is calculated, because definitions vary.
Loan covenant examples, in plain language
| The agreement may say | In practice |
|---|---|
| Borrower shall deliver annual financial statements within a set number of days of year-end | Your accountant's year-end work has a deadline |
| Borrower shall not incur additional indebtedness without lender consent | Ask before taking another loan, lease or advance |
| Borrower shall maintain a minimum debt service coverage ratio | Cash flow must stay comfortably above loan payments |
| No change of control without consent | Selling or bringing in an owner needs the lender's agreement |
What is a debt covenant violation?
A violation, often called a breach, happens when the business fails a covenant: a late financial statement, a ratio below the minimum, a new loan taken without consent. It can happen even when every payment has been made on time. The agreement sets out what the lender may do next, and lenders often start by asking for an explanation, a plan or a fee for a waiver.
If you see a breach coming, contact the lender before the test date. A waiver or amendment negotiated in advance is usually easier than one requested afterwards.
Questions to ask before you sign
- Which covenants apply, and how and when is each one tested?
- How are the financial ratios defined, line by line?
- What happens on a first breach, and is there a cure period?
- Which plans I already have (equipment, a partner, a second location) would need consent?
- Are any covenants tied to other agreements, so that a problem elsewhere counts as a problem here?
Have your attorney review the agreement. Your accountant can tell you whether the business's numbers are likely to stay inside any financial covenant.
Where Keelpark Capital Group fits
We help you understand the conditions in an offer before you accept it, but we do not write or negotiate covenants; the lending partner does. See term loans, where covenants most often appear, and how a request moves.
By Keelpark Capital Group · Updated