- In a loan agreement, covenants generally fall into a few broad categories, each doing a different job for the lender.
- Covenants exist to give the lender early warning and some measure of control if the borrower's financial position deteriorates — well before the loan actually goes unpaid.
Once a lender agrees to finance an Ontario business, the loan agreement almost always comes with a set of ongoing promises — covenants — that go well beyond simply repaying the money on time. Covenants restrict how the business can be run for as long as the loan is outstanding, and breaching one can trigger a default even if every payment has been made in full.
Understanding what covenants typically cover, and which ones are negotiable, puts a borrower in a much stronger position before signing.
What a Covenant Actually Is
A covenant is a contractual promise. In a loan agreement, covenants generally fall into a few broad categories, each doing a different job for the lender.
Affirmative covenants
These require the borrower to actively do certain things throughout the life of the loan, such as:
- Maintaining adequate insurance on secured assets
- Delivering financial statements on a set schedule
- Keeping the business, its licences, and its corporate existence in good standing
- Paying taxes and other obligations as they come due
Negative covenants
These restrict the borrower from taking certain actions without the lender's prior consent, such as:
- Taking on additional debt beyond agreed limits
- Granting security to another lender over the same collateral
- Selling a material portion of the business's assets
- Paying dividends or distributions beyond agreed limits
- Undergoing a change of control or ownership
Financial covenants
These require the business to maintain certain financial metrics — for example, a minimum level of working capital, a maximum ratio of debt to earnings, or a minimum debt-service coverage ratio — tested periodically against the business's financial statements. The specific ratios and thresholds are negotiated deal by deal; there is no standard figure that applies across all Ontario business loans.
Why Lenders Insist on Covenants
Covenants exist to give the lender early warning and some measure of control if the borrower's financial position deteriorates — well before the loan actually goes unpaid. A breached financial covenant, for instance, lets the lender intervene (renegotiate terms, require a paydown, or take enforcement steps) at a point when the business may still have options, rather than waiting until a payment is actually missed.
From the borrower's perspective, covenants can feel intrusive, but they are also the price of financing that might not otherwise be available — a lender extending credit based on projected performance, rather than only hard collateral value, typically wants covenants as a check on that risk.
Common Areas Where Covenants Bite
| Covenant Type | What It Restricts | Typical Borrower Concern |
|---|---|---|
| Additional debt | Taking on new loans or leases | Limits future flexibility to finance growth |
| Distributions | Paying dividends, bonuses, or shareholder loans | Restricts owner compensation timing |
| Asset sales | Selling equipment, real property, or business lines | Can block routine business decisions |
| Change of control | Ownership or management changes | Complicates a future sale or succession plan |
| Financial ratios | Maintaining defined liquidity or leverage levels | Can be breached by a slow season, not mismanagement |
| Cross-default | Default under any other agreement | Turns unrelated problems into a loan default |
Negotiating Covenants Before You Sign
- Ask for the full covenant package early, not just the interest rate and repayment schedule — covenants are often where the real risk sits.
- Push for materiality thresholds and cure periods — a covenant that gives you a defined window to fix a technical breach is far less dangerous than one with no grace period.
- Negotiate carve-outs for ordinary-course transactions — routine equipment upgrades or minor asset sales should not require lender consent every time.
- Watch for cross-default clauses carefully — a default under a different loan, lease, or supplier agreement can cascade into a default here too.
- Understand how financial covenants will actually be tested against your real financial statements, including how seasonal swings in your business might affect compliance.
Frequently asked questions
Can a covenant be breached without the business missing a loan payment?
Yes — this is one of the most misunderstood aspects of covenants. A business can be current on every payment and still be in default because it breached a financial ratio, took on unauthorized debt, or made a distribution the agreement prohibited.
Are loan covenants negotiable, or are they standard terms?
They are generally negotiable, particularly for financially healthy borrowers or those with some leverage in the negotiation. Lenders often start with a broad, protective set of covenants and expect some to be narrowed during negotiation.
What happens if my business breaches a covenant?
This depends on the loan agreement's default provisions — some breaches trigger an automatic default, while others allow a cure period or require the lender to give notice first. Review the specific default clause tied to each covenant rather than assuming a uniform outcome.
Do covenants ever change over the life of the loan?
Yes, if the parties agree to amend the loan agreement — for example, after a temporary dip in performance, a lender may agree to waive or reset a financial covenant, sometimes for a fee or on revised terms.
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