A covenant, by definition, is a type of agreement often found in contracts that obligates one or more parties to either engage or abstain from some specific action. Covenants are unconditional promises that, when breached, entitle the other contracting party to damages, remediation, or termination of the contract.
If you’ve ever signed a contract of any kind you are likely already familiar with the idea that covenants are usually "baked into the agreement." A contract stipulates a lot of details, including what the signatory is committing to do and not do — often using words such as “agree” or “promise.” Most commonly, businesses encounter covenants when borrowing money, in agreements detailing what's being promised in exchange for a loan.
These promises, known as loan or debt covenants, can be as simple as, “I agree to be profitable,” meaning you have to be positive net income; or covenants can be very specific like, “I promise to maintain a minimum of $100,000 cash on hand at all times.”
Before you sign any loan contract, get familiar with the types of debt covenants you might encounter and what you should look out for in startup financing agreements.
What is a debt covenant?
Debt covenants, also referred to as financial covenants, banking covenants, or loan covenants, are conditions set forth within financial contracts (such as loans and bonds) in which the borrower is either obligated or forbidden to undertake a specific action.
Lenders typically use debt covenants as a means of ensuring that a borrower maintains their business in a way that will make the loan payment most likely. It’s a way that lenders can micromanage borrowers to attempt to mitigate risk — a form of “guard rails” that lenders can set up to ensure a business is staying well within a margin of error in its operations.
Types of Debt Covenants
Debt covenants are categorized as either positive or negative.
A positive covenant is an obligation to do something — “you shall.”
A negative covenant is a promise not to do something — “you shall not.”
Be cautious of restrictive debt covenants
Negative covenants are referred to as restrictive covenants because they limit what actions you can take, and that can create new challenges if you're running a startup. We're guessing you did not need another one of those!
Debt covenants are inherently risky for borrowers, and even more so if the covenants are restrictive. It can be easy to accidentally run afoul of overly restrictive covenants, and even those that are easy to meet may be artificially constraining in a way that limit your ability to take creative or bold action.
How do debt covenants work?
A debt covenant lays out the conditions the borrower must fulfill or the actions they must avoid to maintain in good standing with the lender.
Covenants run the gamut from the basics of business operations, such as maintaining the business and running it in a legal manner, to more specific and complex requirements. Many covenants are financial, like specifying the need to maintain a certain growth rate, a minimum amount of runway, or a minimum amount of cash on hand.