A covenant is a binding rule in a debt contract that limits what a borrower can do — or requires specific actions — until the loan is repaid.

How it works

Credit agreements stack multiple covenant types:

• Affirmative covenants — deliver audited financials, maintain insurance, pay taxes
• Negative covenants — no additional debt above a cap, no dividends, no asset sales without consent
• Financial covenants — maintain minimum liquidity, revenue levels, or maximum leverage ratios

Lenders test covenants each quarter. A covenant breach may trigger a default, higher interest, mandatory equity cure, or accelerated repayment. Venture debt often uses lighter covenants than traditional bank loans, but growth-stage facilities can tighten as companies scale.

Founders negotiate covenant baskets — carve-outs that allow certain actions without lender approval, such as small acquisitions or option pool increases.

Why it matters

• Founders: Read covenant schedules before signing. A bridge round or down round can accidentally violate debt-to-equity ratios and freeze operations.
• Investors: Heavy covenant packages signal lender conservatism. Lighter packages may mean higher pricing or reliance on personal guarantees.

Common mistake

Focusing only on interest rate and ignoring covenant headroom. A cheap loan with tight covenants can become a operational straitjacket during a slow quarter.

Related ideas

See also covenant-lite, event of default, venture debt, and amendment fees.