Definition of Covenants
In a financing context, covenants are conditions or restrictions written into debt agreements, such as loans or bonds, that borrowers are required to comply with. They are contractual promises made by the borrower to the lender as part of receiving financing. Covenants are designed to protect the lender by ensuring the borrower maintains financial discipline and avoids actions that could materially increase repayment risk.
What Covenants Include
Covenants can cover a wide range of financial and operational requirements. Common examples include maintaining minimum cash balances, meeting revenue or profitability thresholds, keeping leverage or liquidity ratios within agreed limits, restricting additional debt, limiting asset sales, or prohibiting dividend payments. Covenants may also require regular financial reporting, audits, or notifications of significant business events.
Types of Covenants
Covenants are typically categorized into positive covenants and negative covenants.
Positive covenants require the borrower to take certain actions, such as providing monthly financial statements, maintaining insurance coverage, or complying with reporting obligations.
Negative covenants restrict actions the borrower cannot take without lender approval, such as raising additional debt, selling key assets, changing ownership structure, or exceeding predefined spending limits.
Covenants Explained for a General Audience
Covenants are essentially the rules that come with a loan. When a business borrows money, the lender may say things like, “You must keep at least $X in your bank account,” or “You can’t take on more debt until this loan is repaid.” These rules help ensure the borrower doesn’t overextend itself and remains able to repay the loan. If the rules are broken, the lender can enforce penalties or demand early repayment.
Covenant Breaches and Consequences
If a borrower fails to meet a covenant, this is known as a covenant breach. Depending on the agreement, a breach can trigger penalties, higher interest rates, tighter restrictions, or even immediate repayment of the loan. Because of this, covenant compliance becomes an ongoing operational concern for finance teams, especially during periods of volatility or rapid growth.
Covenants in Venture Debt and Bank Financing
Covenants are common in traditional bank loans and venture debt. While venture debt is often described as “covenant-light” compared to bank financing, it usually still includes some financial or operational conditions. These covenants give lenders ongoing oversight and influence over the borrower’s financial decisions throughout the life of the loan.
Covenants and Non-Dilutive Financing
One reason alternative financing models emphasize the absence of covenants is that covenants can restrict operational flexibility. Financing structures that are not loans—such as true sale or contract-based financing—may have no restrictive covenants because the capital provider is purchasing assets rather than lending against the company’s balance sheet. This allows companies to access capital without ongoing compliance risk or lender control.
Covenants and Strategic Flexibility
Covenants can limit a company’s ability to raise additional capital, invest aggressively, pivot strategy, or respond to market changes. As a result, founders and operators often evaluate the strictness of covenants when comparing financing options, weighing lower cost of capital against reduced freedom.
Summary
Covenants are the conditions attached to borrowed money. They protect lenders by limiting risk, but they can also constrain how a company operates. Financing options with no or minimal covenants provide greater flexibility, while covenant-heavy debt can introduce compliance risk and operational restrictions. Understanding covenants is essential when choosing between debt, venture debt, and alternative non-dilutive financing options.
