Covenants in growth lending

Covenants are promises in a loan agreement. They define what the company must do, what it cannot do without consent and, sometimes, the financial performance or liquidity it must maintain.

They are not standard across growth debt. Some venture debt has few financial tests but extensive reporting and restricted-action covenants. Later-stage growth credit may use regular earnings, leverage or liquidity tests.

The three main groups

Affirmative covenants

Affirmative covenants, also called positive undertakings, often cover reporting, legal compliance, corporate existence, tax, insurance, books and records, lender inspections and protection of secured assets.

A reporting duty can be a covenant even though it does not measure financial performance. Missing a delivery deadline may therefore create a contractual breach.

Build a calendar showing the document, period, due date, signatory and owner. Include event-driven notices, not only monthly and annual reports.

Negative covenants

Negative covenants protect the lender from decisions that could increase risk or move value away from the repayment pool. They commonly restrict additional debt, security, guarantees, acquisitions, investments, asset sales, dividends, share buybacks and changes of business.

The practical flexibility sits in exceptions, thresholds and baskets. A basket is permitted capacity for an action that would otherwise be restricted, such as a limited amount of equipment finance or ordinary-course disposals.

Check which group companies are covered and whether transactions between them are permitted. A harmless-looking transfer can breach a covenant if the wrong entity owns the asset or receives the cash.

Consent means the lender agrees to a restricted action. Obtain it in the form and before the deadline required by the agreement; informal support is not enough.

Financial covenants

A financial covenant converts part of the credit case into a recurring numerical test. The label matters less than the exact definition, test date, calculation period and companies included.

Common growth-company tests

ARR means annual recurring revenue: the annualised value of qualifying recurring income. EBITDA means earnings before interest, tax, depreciation and amortisation. Neither has one universal contractual definition.

Maintenance and incurrence tests

A maintenance covenant must be satisfied at regular test dates or continuously. An incurrence covenant applies only when the company takes a specified action, such as borrowing more or making an acquisition.

A company can pass every quarterly maintenance test yet lack capacity for a proposed acquisition under an incurrence test. The operating calendar must cover both.

Definitions determine the result

Review how cash, debt, revenue and EBITDA are defined; which subsidiaries count; which currencies and accounting rules apply; and what adjustments or pro forma treatment are allowed.

A pro forma calculation tests the covenant as if a transaction or event had occurred for the relevant period. It can be useful but depends on assumptions that must be expressly permitted.

Rebuild calculations independently from the agreement and reconcile inputs to approved accounts. Do not rely only on the lender’s model or the term sheet.

Testing frequency and delivery

The agreement may test monthly, quarterly, annually, on each draw or continuously. A compliance certificate commonly presents the calculation and confirms compliance.

A test date and reporting date are different: the financial condition may be measured at month end while the certificate is delivered later. Management should know the result before the test date.

Covenant headroom

Headroom is the gap between forecast performance and the required threshold. Measure it in the contractual unit and in time: how much worse performance can become, and how many months remain before a likely breach.

Model base and downside headroom monthly through maturity. Include debt draws, repayments, PIK interest, equity timing, customer losses and any step changes in covenant thresholds.

A covenant set comfortably against the original plan can become tight after a budget reset. Update the forecast and board view rather than waiting for the next certificate.

Cures, holidays and resets

Some agreements allow an equity cure, where qualifying new equity proceeds repair a financial test in the specified way. Limits may apply to amount, timing, frequency and the tests affected.

A covenant holiday suspends specified tests for an agreed period. A reset changes future thresholds. Both require documented agreement and may bring fees, pricing changes, new reporting or other protections.

No covenant does not mean no control

A facility advertised as covenant-lite or without financial covenants can still restrict debt, security, disposals and corporate actions, require detailed reporting and contain broad draw conditions or events of default.

For venture debt, minimum liquidity, investor-support or material-adverse-change provisions may perform an early-warning role even when conventional leverage tests are absent.

Negotiating covenants

Negotiate definitions and operating freedom, not only threshold numbers. Ask:

• Does the covenant measure a risk management can control and report reliably?
• Is the threshold supported by a realistic downside, not only the budget?
• Do baskets cover ordinary operations and foreseeable transactions?
• Are test dates, step changes and cure periods workable?
• Can acquisitions, equity rounds and reorganisations be completed without avoidable delay?
• Which breaches block drawings or trigger default?

Operating the covenants

Maintain a covenant register with clause, definition, test, deadline, evidence, owner and escalation threshold. Put financial tests in the monthly forecast and restricted actions in board and transaction checklists.

Escalate an expected breach before it occurs. A waiver addresses a specified breach; an amendment changes the agreement. Neither should be assumed until properly documented.

The bottom line

Growth debt covenants are the operating boundaries of the loan. They combine information, restricted actions and, where applicable, financial tests.

The safest structure uses clear definitions, realistic downside headroom and enough ordinary-course flexibility for the company to operate without turning every routine decision into a lender negotiation.

Where to go next

• What happens if you breach a debt covenant? explains the response to a failed covenant test.
• Events of default sets out the contractual triggers that give lenders additional rights.
• Reporting to growth lenders shows what lenders expect to receive after closing.
• Growth debt term sheets explained shows how to read the whole offer before long-form documents.