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What are covenants?

In the context of debt capital and credit agreements, covenants (also called banking covenants or financial covenants) are restrictions that debt capital providers attach to lending agreements to provide guidelines for their borrowers.

In other words, the covenants of a lending agreement are the things that a borrower has to do (or not do) in order to maintain access to their source of capital. Covenants are legally binding and are often outlined in credit agreements.

For fast-growing startups that rely on debt capital for growth, covenant compliance is critical, as failing to honor, or "tripping," a covenant can reduce or block access to debt capital.

The two key types of debt covenants are positive debt covenants (also referred to as affirmative covenants) and negative debt covenants.

Positive debt covenants are conditions that borrowers must fulfill in order to keep receiving funds. A great example here is having an up-to-date financial statement in place with a lender. This is something that a borrower might have to do do every month (or quarter) in order to keep receiving credit.

Negative debt covenants define what borrowers can't do. For example, a negative debt covenant might state that a borrower can't raise more debt capital without first repaying their lenders.

What happens if borrowers violate covenants?

It's not uncommon for borrowers to violate debt covenants, but the severity of the consequences depend on the agreement between lender and borrower, as well as the nature of the violation.

For example, if a borrower neglects to submit an updated financial statement at the end of the year, the lender can simply request that they provide an update, without any severe consequences.

On the other hand, if a borrower violates a covenant by issuing more debt, it is possible that their initial lender might terminate the debt agreement entirely.

For some real-life examples of covenant violations and consequences, check out the "Real-World Examples" section in the Investopedia article here.

Why do debt covenants matter?

For high-growth companies that use debt capital to fund operations or scale their businesses, covenants matter because covenant compliance determines the extent to which these companies can access capital.

Companies seldom violate debt covenants on purpose. It's more often the case that the complexity of covenants (or the lack of a system for tracking covenant compliance) leads to an oversight on the part of borrowers.

When that happens, company funding can grind to a halt.

The best way to ensure covenant compliance is to implement technology that tracks covenant compliance in near real time. Ideally, these systems can issue early warnings to borrowers before they violate covenants, and provide guidance on how to stay in compliance with covenants on an ongoing basis.

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All information presented herein is for informational purposes only, and Finley Technologies, Inc. does not assume any liability for reliance on the information provided. Before making any decisions that may affect your business, you should consult a qualified professional advisor.


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