Loan Covenants Explained: What Business Owners Should Negotiate
A loan agreement is more than a promise to repay. Most senior and subordinated debt facilities include covenants, which are ongoing conditions the borrower must satisfy during the term of the loan.
Most owners pay close attention to interest rates and amortization schedules. Fewer give the same attention to covenants. Yet covenants often determine how much flexibility the business will have in the years ahead, and how the lender will respond if performance varies.
For owner-managed businesses in Vancouver and across Canada, understanding covenants is a basic part of evaluating any financing.
What Covenants Are
Covenants are commitments made by the borrower to the lender. They typically fall into three categories:
• financial covenants, which require the business to maintain certain financial metrics
• affirmative covenants, which require the business to do specific things
• negative covenants, which prohibit the business from doing specific things
In a typical loan agreement, all three appear together, often spanning several pages of dense text.
Financial Covenants
Financial covenants are tested periodically (monthly, quarterly, or annually) against the business’s financial results. If a covenant is breached, the lender may have rights ranging from waiver requests to acceleration of the loan.
Most financial covenants fall into a small number of categories:
• leverage ratios
• coverage ratios
• minimum profitability or earnings
• liquidity
Each measures a different aspect of the business’s ability to service the debt.
The Most Common Financial Covenants
Leverage covenants typically include:
• total funded debt to EBITDA
• senior funded debt to EBITDA
• debt to tangible net worth
Coverage covenants typically include:
• fixed charge coverage ratio
• debt service coverage ratio
• interest coverage ratio
Each covenant has multiple definitions in the market. Two loan agreements using the term "fixed charge coverage ratio" may calculate it very differently. The definition matters as much as the threshold.
Affirmative Covenants
Affirmative covenants require the borrower to take certain actions. Common examples include:
• maintaining insurance at specified levels
• paying taxes and other liabilities on time
• maintaining the business and its assets in good condition
• complying with laws and material contracts
• providing the lender with access to information and personnel
These are typically less negotiated than financial covenants, but they impose ongoing operational obligations that should be reviewed against the business’s actual practices.
Negative Covenants
Negative covenants prohibit certain actions without the lender’s consent. Common examples include:
• incurring additional debt
• granting security interests in assets
• paying dividends or distributions to shareholders
• making acquisitions or large capital expenditures
• selling material assets
• changing the nature of the business
Many negative covenants include carve-outs that allow specified amounts or types of activity. Negotiating these carve-outs is one of the more practical ways to retain flexibility.
Reporting Covenants
Reporting covenants require the borrower to deliver financial and compliance information on a regular basis. Common requirements include:
• monthly internal financial statements
• quarterly covenant compliance certificates
• annual audited or reviewed financial statements
• annual budgets
• notice of material events
Reporting obligations can be substantial, especially for businesses that have not previously had formal external reporting requirements. The cost and time involved should be factored into the decision to take on the facility.
How Covenants Affect the Business
Covenants do not only matter when they are breached. They affect day-to-day decisions in subtle ways. Examples include:
• influencing whether to pay shareholder distributions in a given year
• shaping decisions about timing or size of capital expenditures
• affecting acquisitions or strategic investments
• constraining when and how additional financing can be raised
• determining the timing of refinancings to relieve restrictions
Owners who view covenants as background paperwork often discover late that the loan agreement is actively shaping management decisions.
Cure Rights and Equity Cures
Some loan agreements allow the borrower to cure a covenant breach by injecting fresh equity into the business, often referred to as an equity cure.
Typical terms include:
• a defined number of cures available during the term
• limits on how often cures can be used in consecutive periods
• rules for how the injected equity is treated in covenant calculations
Equity cures can save a business from a technical default, but they should not become a substitute for managing the underlying performance.
Why Covenant Headroom Matters
Headroom is the gap between the actual financial result and the covenant threshold. A facility with tight covenants may meet the bank’s internal credit committee comfortably but leave little room for operational variance.
Healthy headroom matters because:
• actual results in private businesses are rarely perfectly predictable
• seasonality, one-time costs, and timing differences can move covenant ratios significantly
• investments in growth often depress short-term earnings
• tight covenants amplify the impact of small surprises
In the loan negotiation, headroom is more important than the headline interest rate in many cases. A facility priced 25 basis points higher with materially more headroom is often the better facility.
Negotiating Covenants Up Front
The right time to negotiate covenants is before signing, not afterward. Once a covenant is in place, changing it later usually requires the lender’s consent and may involve fees, amendments, or other concessions.
Key negotiation points include:
• the choice of covenants (some, not all, are appropriate)
• the definitions of the metrics
• the testing frequency
• the level of the thresholds
• the size and scope of carve-outs in negative covenants
• the availability and terms of cure rights
A facility with a slightly higher interest rate and fewer or looser covenants is often a better facility for an owner-managed business than the inverse.
What to Do If You Trip a Covenant
If a covenant is breached, the first step is to engage the lender quickly and constructively. Most lenders prefer to work through a covenant issue than to take more aggressive action.
Common outcomes include:
• a waiver of the breach for a defined period
• an amendment to the covenant thresholds going forward
• a temporary tightening of reporting or other obligations
• a re-pricing of the facility
• a requirement to inject equity
In serious cases, the lender may require a financial advisor or take steps to protect their position. Early communication usually produces better outcomes than waiting for the lender to discover the issue.
How KitsWest Capital Helps
KitsWest Capital advises businesses on debt and capital matters, including new facility negotiations, refinancings, and covenant amendments. Our role typically begins with a clear view of what the business actually needs from the financing, both in terms of capital and operating flexibility.
Typical involvement includes:
• preparing lender-ready materials that anticipate covenant discussions
• negotiating term sheets and definitive agreements
• comparing offers from multiple lenders, including the covenant package, not just the headline price
• coordinating with legal counsel on documentation
• supporting clients through covenant amendments or waivers when needed
This work often integrates with our M&A advisory practice, particularly in acquisition financings where covenant flexibility affects the buyer’s ability to execute a growth plan post-closing.
Final Thoughts
Covenants are not paperwork. They are the operating constraints of the business for the term of the loan. A facility with the right covenants can support growth, acquisitions, and shareholder returns. A facility with the wrong covenants can quietly limit all three.
For owners reviewing a term sheet or weighing competing offers, covenants deserve at least as much attention as price. The right time to fix them is now.
Speak with an Advisor
If you are evaluating a business sale, acquisition, unsolicited offer, or valuation matter, KitsWest Capital welcomes confidential discussions.
