What is a Loan Covenant?

A loan covenant is a specific condition written into a commercial loan agreement. While the interest rate tells you the cost of the money, the covenant tells you the rules of behavior you must follow while you have that money.

Technically, it is a clause that requires the borrower to fulfill certain conditions or forbids the borrower from undertaking certain actions. For a founder, it serves as a tripwire. You can make every monthly payment on time and still lose your business if you violate a covenant.

Banks and lenders use these tools to mitigate risk. They do not want to wait until you are bankrupt to step in. They want the legal right to intervene the moment your financial health starts to deteriorate.

Covenants generally fall into two categories. You need to understand the difference to negotiate them effectively.

Affirmative Covenants are things you promise to do. These are active obligations.

• You must provide audited financial statements every quarter.
• You must maintain insurance on your key assets.
• You must pay your taxes on time.

Negative Covenants are things you promise not to do. These are restrictions on your freedom.

• You cannot take on additional debt from another lender.
• You cannot sell key equipment without permission.
• You cannot issue dividends to shareholders.
• You cannot acquire another company.

Negative covenants can be stifling for a high-growth startup. If you need to pivot quickly or buy a competitor, a strict negative covenant forces you to ask your banker for permission first.

The most dangerous covenants are financial. These are mathematical ratios that you must maintain at all times.

For a traditional business, this might be a “Debt Service Coverage Ratio.” This requires your profit to be a certain multiple of your loan payments. If your profit dips, you are in default.

For venture-backed startups that are burning cash, lenders often use different metrics. A common one is “Minimum Cash Balance.” The bank might stipulate that you must keep at least six months of burn in their account at all times. If your bank balance drops below that number for even one day, you have breached the covenant.

What happens if you break a rule? This is known as a “Technical Default.”

Even if you have plenty of cash to pay the loan, a covenant breach gives the lender significant power. They can usually:

• Charge a penalty fee.
• Increase the interest rate.
• Demand immediate repayment of the entire loan principal.

This last option is called “calling the note.” For a startup, this is usually a death sentence. It forces you to find a massive amount of cash overnight or declare bankruptcy.

When taking on venture debt or a line of credit, the interest rate is often a distraction. The real negotiation happens in the covenants.

A prudent founder will negotiate for “covenant-lite” structures or ensure that the definitions of the ratios are loose enough to account for the volatility of startup life. You never want to be in a position where a bad month of sales hands control of your company over to a bank officer.