What it means
Covenants come in two shapes. Positive covenants say what you must do, such as filing audited accounts within 90 days of the year end, while restrictive covenants say what you must not do, such as borrowing more money without the lender's written consent.
Lenders rely on restrictive covenants because a loan agreement is signed once but the risk runs for years. The clauses act as an early warning system and give the bank a seat at the table if the business starts to drift, long before an interest payment is actually missed.
In lending, restrictive covenants usually take one of three forms. Financial maintenance covenants set a ratio the borrower must stay inside and are tested every quarter, incurrence covenants block a specific action such as a large acquisition or an asset sale, and a negative pledge stops the borrower from granting security over the same assets to another lender.
Employment and sale contracts use restrictive covenants differently, typically as non-compete, non-solicitation and confidentiality clauses. Courts in most jurisdictions enforce them only where they are reasonable in scope, geography and duration, so a two year worldwide ban on working anywhere in an industry is far more likely to be struck down than a six month ban on approaching a named list of clients.
The nuance that trips people up is that breaching a covenant is not the same as failing to pay. A breach normally triggers a technical default, which gives the lender the right to demand immediate repayment, reprice the loan or impose fresh conditions, and in most real cases the outcome is a negotiated waiver with a fee attached rather than enforcement.
In practice
Real-world examples
Example 1
A furniture manufacturer has a bank facility with a covenant capping dividends at 50% of net income. The board wants to pay out $2,000,000 on net income of $3,000,000, but the covenant limits the payment to $1,500,000, so the directors declare $1,500,000 and keep the balance in the business.
Example 2
A founder sells her software agency and signs a three year non-compete covering the country she trades in, plus a two year non-solicitation clause covering staff and clients. The buyer insists on it because most of what it is paying for is the client relationships, not the desks and laptops.
Example 3
A distribution company signs a lease containing a covenant that the unit may only be used for warehousing. When it later wants to run a trade counter from the same site, it has to negotiate a variation with the landlord and pay a small fee for consent.
Think of it
Think of a restrictive covenant like the rules parents set when lending their car to a teenager. You can use the car to get to school, but you must not drive out of the county, you must keep fuel in the tank, and you must not let your friends drive. These rules do not mean your parents do not trust you, but they protect their valuable asset from unnecessary risk.
Formula
Calculation
Most financial restrictive covenants are written as a ratio test. A very common one is the leverage covenant:
Net debt / EBITDA must not exceed 3.0 times
Worked example. Harbour Tools has total borrowings of $13,500,000 and cash of $1,500,000, so net debt is $13,500,000 - $1,500,000 = $12,000,000. EBITDA for the last twelve months is $5,000,000.
Covenant ratio = $12,000,000 / $5,000,000 = 2.4 times
Harbour Tools is comfortably inside the 3.0 times limit, and its headroom can be measured from either direction. On the debt side, the maximum net debt permitted is 3.0 x $5,000,000 = $15,000,000, so the company could borrow a further $15,000,000 - $12,000,000 = $3,000,000 before breaching. On the earnings side, EBITDA could fall to $12,000,000 / 3.0 = $4,000,000, a drop of $1,000,000 or 20%, before the same covenant is broken. That 20% cushion is what the finance director actually monitors each month.Case study
Seen in the real world
Northgate Bakeries is a fictional regional baker used here as an illustrative case. When it borrowed $9,000,000 to fit out a second production line, the loan carried two restrictive covenants: net debt must stay below 3.0 times EBITDA, and no single asset disposal above $500,000 without lender consent.
Eighteen months later a wet summer and a lost supermarket contract pushed EBITDA down from $4,200,000 to $2,900,000, and the leverage ratio moved from 2.0 times to 3.1 times. Nothing had been missed on the payment schedule, but Northgate was in technical default the moment the quarterly certificate was signed.
The finance director went to the bank before the test date rather than after it, with a costed recovery plan and a proposal to sell a surplus depot. The bank granted a waiver for two quarters, charged a $45,000 fee, raised the margin slightly and reset the covenant to 3.5 times, which is a very ordinary outcome when a borrower brings the problem forward early.
Watch out
Common mistakes
- Assuming a covenant only bites if you miss a payment. Most breaches happen while every instalment is being paid on time, because the test is a ratio, not a cash payment.
- Treating the covenant definitions as ordinary English. Loan agreements define EBITDA, net debt and adjustments in their own precise way, and the contractual definition, not the version in the management accounts, is what gets tested.
- Signing an employment non-compete without checking how wide it is. An unreasonably broad clause may be unenforceable, but arguing that point in court is slow and expensive, so it is far cheaper to narrow the wording before signing.
Questions
People also ask
What is the difference between a positive and a restrictive covenant?
A positive covenant obliges you to do something, such as supply monthly accounts, while a restrictive covenant forbids something, such as taking on new debt.
Can a restrictive covenant be removed or relaxed?
Yes, lenders regularly grant waivers or reset thresholds, usually in exchange for a fee, a higher margin or extra security, and the request is far better received before the breach than after it.
Do restrictive covenants appear in the published accounts?
The detailed thresholds often do not, but the notes to the financial statements usually confirm that borrowings are subject to covenants and whether any were breached during the year.