For many businesses, borrowing is an essential part of growth. Loans provide the capital needed to expand operations, acquire assets, or weather economic downturns. Whether you are a small manufacturer buying new equipment, a family-owned retailer opening a second location, or a growing tech company hiring staff, access to credit can be the difference between stagnation and success.

Most business owners pay close attention to headline terms like interest rates, repayment schedules, and collateral. That makes sense — those terms are the most visible and easiest to understand. But the real risks often lie hidden in a less obvious part of the agreement: the loan covenants.

Loan covenants are the promises you make to a lender about how you will run your business during the life of the loan. On the surface, they may seem like routine conditions. In practice, they can create unexpected constraints, limit your flexibility, and even lead to default if not properly understood and negotiated.

Let’s break down the most common covenant categories, the hidden risks they create, and the safeguards you can use to protect your business.

Financial Covenants

Financial covenants are among the most common provisions in loan agreements. They often require a borrower to maintain certain ratios, margins, or levels of liquidity. On paper, these conditions seem reasonable. Lenders want assurance that your business is financially healthy enough to repay the loan.

Common Types of Financial Covenants

• Debt-to-equity ratio: You must maintain a balance between borrowed money and invested equity. 
• EBITDA margin requirements: Your earnings before interest, taxes, depreciation, and amortization must not fall below a specified threshold. 
• Minimum net worth or liquidity: You must keep a set amount of assets or cash reserves.
  

Why They Are Risky

Here’s the problem: financial covenants rarely account for the real-world ups and downs of running a business.

Imagine you own a seasonal business — say, a landscaping company. Your revenue peaks in spring and summer, then slows dramatically in winter. If your loan requires you to maintain a specific EBITDA margin every quarter, one slow season could trigger a covenant breach. Even if you are current on payments, your lender may have the right to call the loan, demand penalties, or increase interest rates.

Similarly, a temporary downturn, a one-time expense, or a new investment in growth could cause you to “trip” a covenant. These breaches are sometimes called technical defaults. They are not failures to pay but violations of contractual promises. The consequences can be just as severe.

Real-World Example

During the 2020 pandemic, many otherwise healthy businesses faced sudden drops in revenue. Those with loans tied to financial ratio covenants found themselves in technical default overnight. Lenders suddenly had leverage to renegotiate terms or demand concessions, leaving borrowers vulnerable at the worst possible moment.

Legal Safeguards

The good news is that financial covenants are negotiable. Business owners can:

• Push for ratios that reflect seasonal variations. 
• Negotiate annual tests instead of quarterly ones. 
• Build in cure periods, giving time to correct a breach before penalties kick in.
  

An experienced attorney can ensure the numbers work for your reality, not just the lender’s spreadsheet.

Operational Restrictions

While financial covenants govern your balance sheet, operational covenants dictate how you run your business. These restrictions often come as a surprise to borrowers.

Common Operational Restrictions

• Limits on dividend distributions. 
• Caps on capital expenditures. 
• Restrictions on acquisitions or expansion. 
• Prohibitions on taking on additional debt.
  

How They Can Hurt Your Business

Imagine you run a profitable small business and want to reward yourself with a dividend after years of reinvesting profits. If your loan prohibits distributions without lender approval, you may find that your hard-earned reward is off-limits.

Or consider a growing company that wants to acquire a competitor. If the loan prohibits acquisitions, you may need lender approval to move forward. That approval is never guaranteed.

For small-to-mid businesses, these restrictions can feel like handcuffs. You borrowed money to grow, but the covenants may prevent you from making the very moves that drive growth.

A Mini Case Study

A client of ours, a family-owned distribution business, secured a sizable loan to expand operations. The loan contained restrictions on additional debt. Later, when they wanted to lease new equipment with financing, the lender refused to consent. The business faced a tough choice: operate with outdated equipment or violate the covenant.

With legal help, they were able to renegotiate the terms, but the experience highlighted how operational covenants can clash with real-world business needs.

Legal Safeguards

• Negotiate carve-outs for routine transactions like leasing equipment. 
• Ensure restrictions align with your growth strategy. 
• Build in flexibility for acquisitions or capital expenditures.
  

A legal advisor can help balance lender protections with borrower flexibility, ensuring your business isn’t boxed in by overly rigid terms.

Reporting Requirements

Loan agreements almost always require regular reporting. Lenders want visibility into your financial health, and they rely on timely updates to track covenant compliance.

Typical Reporting Obligations

• Quarterly or monthly financial statements. 
• Annual audited statements. 
• Compliance certificates signed by management. 
• Notices of material changes or litigation.
  

Why This Matters for Small Businesses

Large companies have accounting teams dedicated to preparing reports. Small businesses often do not. Preparing financial statements, meeting deadlines, and ensuring accuracy can be overwhelming for lean teams.

Missing a reporting deadline, even inadvertently, can trigger a technical default. Lenders may use this as leverage to renegotiate terms, impose fees, or restrict your options.

Real-World Example

A small tech startup we worked with was required to deliver quarterly financials within 30 days of quarter-end. Their one-person finance team struggled to keep up, and they missed a filing deadline by two weeks. The lender immediately issued a default notice, even though the company was financially healthy and current on payments.

The situation was resolved, but it caused unnecessary stress, legal fees, and a strained relationship with the lender.

Legal Safeguards

• Negotiate reasonable timelines for reporting. 
• Request grace periods for inadvertent delays. 
• Clarify what constitutes a “material” event requiring notice. 

With careful review, reporting obligations can be aligned with your capabilities, preventing avoidable breaches.

Change of Control Provisions

Change of control covenants address what happens if ownership of the business shifts. For some lenders, a sale, merger, or restructuring triggers automatic repayment or requires prior approval.

Why This Matters for Business Owners

Many small business owners eventually plan to sell, merge, or pass the company to family members. A strict change of control provision can derail those plans.

Imagine you built a successful business and want to sell to a larger company. If your loan requires immediate repayment upon a sale, the deal could collapse unless the buyer agrees to assume or refinance the debt. In some cases, lenders may refuse approval or demand concessions.

Real-World Example

We represented a business owner who wanted to sell her company to a private buyer. The loan agreement contained a change of control clause requiring lender consent. The lender used this as leverage to demand early repayment with penalties. This nearly derailed the deal. After intense negotiation, we were able to structure a refinancing, but the ordeal reduced the seller’s proceeds and added months to the process.

Legal Safeguards

• Negotiate exceptions for family succession or specific scenarios. 
• Ensure repayment terms in change of control events are realistic. 
• Seek provisions that allow for lender consent not to be “unreasonably withheld.” 

For any business with long-term plans, protecting exit flexibility is just as important as managing interest rates.

Safeguards for Borrowers

The risks in loan covenants are real, but they are not inevitable. Most covenants are negotiable, and with the right safeguards, borrowers can strike a balance between lender security and business flexibility.

Key Safeguards to Consider

1. Review carefully: Don’t skim over the covenant sections. They are as important as the repayment terms. 
2. Seek flexibility: Negotiate ratios, thresholds, and restrictions that reflect your business model and growth plans. 
3. Negotiate cure periods: Build in time to fix breaches before they escalate into defaults. 
4. Plan for growth and exit: Make sure covenants allow room for acquisitions, expansion, and eventual sale. 
5. Get expert counsel: Work with attorneys and financial advisors who understand the nuances of loan agreements and can spot hidden risks. 

By approaching covenants proactively, you protect your business’s ability to thrive while still meeting lender requirements.

Final Thoughts

Borrowing can be a powerful tool for growth, but only if you understand the strings attached. Loan covenants are not boilerplate language. They are enforceable obligations that can shift control of your business to your lender if ignored.

Before you sign, make sure you know exactly what you are agreeing to. Protect your flexibility. Safeguard your future. Negotiate terms that work for you.

At Carbon Law Group, we help business owners navigate financing agreements so they can access capital without sacrificing control. If you are exploring a new loan or refinancing an existing one, now is the time to put safeguards in place — before you sign.

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