TL;DR: A covenant is a contractual condition in a loan agreement that the borrower must maintain throughout the life of the loan. Covenants protect the lender's position by requiring the borrower to meet certain financial or operational thresholds, or to seek lender approval before taking specific actions.
When a lender provides capital, the loan agreement includes covenants: conditions the borrower agrees to uphold. If a borrower breaches a covenant there might be consequences, for example, the lender may be able to declare a default, accelerate repayment, or insist the borrower cut costs or raise equity. Covenants are not penalties, they are early warning mechanisms that give lenders visibility into material changes in the borrower's situation.
Covenants appear in all forms of debt financing, including bank loans, mezzanine debt, and venture debt. The number, type, and strictness of covenants vary significantly by lender and product. Some loans may have no covenants, other than regular payment of interest; others may have several different covenants.
Require the borrower to maintain specific financial metrics. Common examples in venture debt:
Actions the borrower must take. Examples: maintain insurance, provide monthly financial statements, notify the lender of material adverse changes.
Actions the borrower must not take without lender approval. Examples: incur additional debt above a threshold, make acquisitions, pay dividends, or change the business materially.
A covenant breach (also called a covenant violation or event of default) occurs when the borrower fails to meet a covenant condition. The immediate consequences depend on the loan agreement (reason for the breach, severity, importance of the covenant, etc.):
Most lenders prefer to work through covenant breaches rather than accelerate. Acceleration is a last resort, lenders are not in the business of liquidating assets. But a breach may give the lender significant leverage in any renegotiation.
How many covenants does a typical venture debt deal include? Venture debt may have no material covenants, but typically includes one or two financial covenants, compared to four or more in a bank facility. Flow Capital generally uses one financial covenant co-designed with the borrower and tailored to the borrowers own financial model, plans and targets.
Can covenants be negotiated? Yes. Covenant levels and types are negotiated at the term sheet stage. Founders should push for covenants tied to metrics they can control and that reflect their actual financial plan.
What happens if I breach a covenant? Depends on the lender and the severity of the breach. Most lenders will work with borrowers on a waiver or amendment. Full acceleration is uncommon unless the breach signals a serious deterioration in the business. Notify your lender proactively, surprises make lenders less flexible.
Are covenants the same as conditions precedent? No. Conditions precedent are requirements that must be met before the loan funds. Covenants are ongoing obligations throughout the loan term.
Related terms: Capital Stack
