Loan Covenants in Ontario Business Acquisition Financing: What Buyers Agree To

Closing a business acquisition loan feels like the finish line, but the loan agreement itself is really the start of an ongoing relationship — one governed by covenants, the promises you make to the lender about how the business will be run and how it will perform. Covenants are easy to skim past during closing, when everyone is focused on getting the deal done. They deserve closer attention, because breaching one can put your loan — and your business — at risk long after the purchase is complete.

This article explains the two broad categories of covenants a buyer typically agrees to, what a breach can mean, and what to negotiate before you sign.

Financial Covenants: Promises About Numbers

Financial covenants require the business to maintain certain financial metrics, tested periodically (often quarterly or annually) for as long as the loan is outstanding. Common categories include:

• Debt service coverage — a measure of whether the business's cash flow comfortably covers its loan payments.
• Leverage ratios — limits on how much total debt the business carries relative to its earnings or equity.
• Working capital minimums — requirements to maintain a certain level of current assets over current liabilities.
• Minimum tangible net worth — a floor on the business's net worth after excluding intangible assets like goodwill.

The specific ratios, thresholds, and testing frequency are negotiated deal terms set by the lender's underwriting for your particular loan — there is no standard set of numbers that applies across all Ontario acquisition loans, and you should not assume any particular ratio without reviewing your own loan agreement.

Operating Covenants: Promises About Conduct

Operating covenants (sometimes called negative covenants) restrict what the business can do without the lender's consent, regardless of how the financial numbers look. Common examples include restrictions on:

• Taking on additional debt beyond what the loan agreement permits.
• Selling, leasing, or otherwise disposing of significant assets outside the ordinary course of business.
• Paying dividends or distributions to shareholders above agreed limits.
• Changing the nature of the business or making a significant acquisition of another business.
• Granting security interests to other lenders that would rank ahead of, or alongside, the acquisition lender's own security.

Operating covenants are often the ones that catch new business owners off guard — a buyer used to running their own affairs freely may not realize that ordinary decisions, like taking on a lease for a second location or bringing in an investor, may require the lender's consent under the loan agreement.

Reporting Covenants: Keeping the Lender Informed

Alongside financial and operating covenants, most acquisition loans include reporting obligations — providing the lender with financial statements, compliance certificates, and notice of any material changes to the business on a regular schedule. Missing a reporting deadline can itself be treated as a covenant breach, separate from whether the underlying financial or operating covenants were actually met.

What Happens If You Breach a Covenant

1. The breach is identified — either by the borrower's own reporting or by the lender's review of financial statements.
2. The loan agreement typically defines the breach as an event of default, whether or not the business is otherwise current on its payments.
3. The lender decides how to respond. Lenders don't always accelerate a loan or call it immediately on a technical breach — many will discuss a waiver or amendment, particularly for a borrower with an otherwise good track record.
4. A waiver may be negotiated, where the lender formally agrees not to enforce its rights arising from that specific breach, sometimes in exchange for a fee, tighter terms, or additional reporting going forward.
5. If no resolution is reached, the lender may exercise its default remedies, which can include demanding repayment of the full loan, enforcing security, or other remedies set out in the loan agreement — the specific remedies available depend entirely on what the loan agreement and security documents say.

Negotiating Covenants Before You Sign

• [ ] Understand exactly which financial ratios apply, how they're calculated, and how often they're tested
• [ ] Confirm what operating decisions require the lender's prior consent versus notice only
• [ ] Ask whether there's a cure period before a breach becomes a formal default
• [ ] Understand the reporting schedule and what's required to stay compliant
• [ ] Have a lawyer review how the covenants interact with your purchase agreement's post-closing obligations (e.g., earn-outs, working capital adjustments)
• [ ] Model your projections against the proposed covenant thresholds before agreeing to them, so you know how much room you actually have

Covenants are negotiable, particularly around cure periods, testing frequency, and consent thresholds for routine business decisions — a lawyer reviewing the loan agreement alongside your business plan can flag terms that look workable on paper but would be tight in practice.

Frequently asked questions