Glossary
Covenant
A condition in the loan agreement you must keep meeting for the life of the loan. Breaching one puts you in default even if every payment has been made on time.
Covenant: A condition in the loan agreement you must keep meeting for the life of the loan. Breaching one puts you in default even if every payment has been made on time.
Why it matters
Most borrowers assume default means missing a payment. It does not. A covenant breach is a default, and it can happen in a quarter where you paid everything on schedule and the business was profitable.
A covenant requiring you to maintain debt service coverage of 1.25x, breached in a soft quarter, entitles the lender to act — up to and including accelerating the loan.
The two kinds
| Type | Examples |
|---|---|
| Financial | Minimum debt service coverage. Maximum debt to net worth. Minimum current ratio. Minimum net worth. Tested quarterly or annually against your statements. |
| Affirmative and negative | Provide financials within X days. Maintain insurance. Do not take on additional debt. Do not sell major assets. Do not change ownership. Do not distribute profits above a limit. |
What usually happens on a breach
Rarely immediate foreclosure. Typically: the lender notices at the next reporting date, raises it, and asks for an explanation. The realistic outcomes are a waiver for that period, an amendment resetting the covenant, a fee, a rate increase, or tighter reporting.
What determines which you get is largely whether you raised it first. A borrower who calls to say “we will miss the coverage test this quarter, here is why and here is the plan” is managed. A lender who discovers it unannounced treats it as a credibility problem as much as a financial one.
What to ask before you sign
- Exactly which covenants apply, how is each calculated, and how often is it tested?
- Run the calculation on my last two years — would I have passed?
- What is the cure period, and is there an equity cure?
- What happens on a first breach, in practice?
- Does breaching here trigger cross-default elsewhere?