What are Covenants?

Nearly all kinds of agreements include covenants. A covenant is a promise to do something — or not to do something, in the case of a “negative” covenant.

In a loan agreement, covenants help the lender ensure that the business will remain as it expects during the term of the loan. For borrowers, covenants restrict what you can and can’t do with the business. Both sides will want to be careful to review and negotiate covenants that are important to them, to ensure that they can live with them during the life of the deal.

Sometimes lenders and borrowers use the term “covenants” when they are referring to financial covenants in a loan agreement. A financial covenant, such as a leverage test or a minimum EBITDA requirement, is based on financial data and is a test you can run by performing calculations. These are typically ratios that are tested quarterly with minimum (or maximum) levels that must be met at each quarter end.

There are many other types of covenants in loan deals, though. Some are “affirmative” covenants where the borrower agrees, for example, to provide copies of financial statements regularly or maintain business insurance. Some are “negative” covenants, where the borrower agrees to not take on additional debt or agrees not to pay dividends to shareholders.

All of these are important to carefully consider, as they will affect how the business is run — and what protections the lender has. Remember to always review and negotiate the covenants.

Susan Alker is a California attorney with over 20 years of experience advising lenders and commercial borrowers.