Getting finance can be a major growth moment for your startup or small business - whether you’re hiring, buying equipment, expanding into a new space, or smoothing out cashflow.
But once a lender says “yes”, the legal paperwork often comes with a set of ongoing rules called loan covenants. If you’ve ever skimmed a facility agreement and seen pages of promises, ratios, reporting obligations and “events of default”, you’ve already met them.
Loan covenants can feel intimidating at first, but they’re also manageable when you understand what they are, what they’re trying to achieve, and how to negotiate terms that actually fit how your business operates.
Below, we’ll walk you through what loan covenants are, the types you’re likely to see in Australia, common traps for startups and SMEs, and practical steps you can take to reduce the risk of an accidental breach.
What Are Loan Covenants (And Why Do They Matter)?
A loan covenant is a promise you make to a lender as part of a loan agreement. It’s a rule that applies during the life of the loan - not just at the start.
In plain terms, loan covenants usually do one (or more) of the following:
- Tell you to do something (e.g. provide monthly financial reporting).
- Tell you not to do something (e.g. don’t take on extra debt without consent).
- Require you to stay within certain financial boundaries (e.g. maintain a minimum cash balance or meet a debt service coverage ratio).
Why do they matter? Because a covenant breach can trigger serious consequences. Depending on the agreement, it may allow the lender to:
- increase interest or fees
- require extra security
- restrict further drawdowns
- treat the breach as an “event of default” and demand repayment
Not every breach leads to worst-case outcomes, but it gives the lender leverage - which is exactly why you want covenants you can realistically comply with.
Loan Covenants vs Loan Security: What’s The Difference?
It’s common to see loan covenants alongside security arrangements. They’re related, but different:
- Security is what the lender can enforce against if you don’t pay (e.g. a charge over business assets under a general security agreement).
- Loan covenants are the ongoing behavioural and financial rules you agree to follow.
Many Australian business loans will also involve registration on the PPSR (Personal Property Securities Register) so the lender’s security interest is publicly recorded. In most cases, the lender (or their lawyers) handles the PPSR registration - but your loan documents may still require you to help with information, consents or additional steps if needed.
Why Do Lenders Use Loan Covenants?
From your perspective, a loan is about funding growth. From a lender’s perspective, it’s about managing risk over time.
Loan covenants are designed to give lenders early warning signs that something might be changing in your business - before you reach the point where repayment becomes difficult.
Most loan covenants aim to protect the lender in three practical ways:
This is where reporting covenants come in (management accounts, budgets, cashflow forecasts, KPI reporting). For startups and SMEs, this can feel like a lot - but it’s also one of the more negotiable areas if you set clear expectations about what you can produce and when.
2) Stability: Preventing Risky Changes Mid-Loan
Lenders often want to stop major business changes that could increase risk, such as:
- taking on extra debt
- selling key assets
- changing ownership/control
- moving money out of the business (dividends/distributions)
Financial covenants can be a “dashboard” for the lender - they help the lender track whether the business is still in the range originally assessed.
This is often the area that causes the most stress for startups and high-growth businesses, because performance can be uneven (especially when you’re scaling quickly).
Common Loan Covenants Australian Startups And SMEs See
Every loan is different, but most loan covenants fall into a handful of categories. The key is understanding which ones apply to your business and where the real risk points are.
These covenants require you to provide information at set times or on request. Examples include:
- monthly or quarterly management accounts
- annual financial statements
- budgets and forecasts
- notice of litigation, regulatory notices or major disputes
- confirmation that taxes and superannuation are up to date (generally - you should get tax and accounting advice specific to your situation)
Practical tip: reporting covenants often become a problem when the timing is unrealistic (e.g. accounts due within 7 days of month-end) or when the covenant requires “audited” statements that you don’t usually prepare.
2) Positive Covenants (Things You Must Do)
Positive covenants are promises that you will do certain things during the loan term. Common examples:
- operate your business properly and lawfully
- maintain insurance
- keep proper books and records
- use the loan funds for an agreed purpose
- maintain key registrations/licences
These might sound standard, but the devil is in the detail. “Maintain insurance” may mean specific types of cover and minimum policy values.
3) Negative Covenants (Things You Must Not Do)
Negative covenants restrict certain actions without lender consent. For startups and SMEs, these are often the covenants that can accidentally slow down growth if drafted too broadly.
Common negative covenants include restrictions on:
- incurring additional financial debt
- granting security to other parties
- selling or disposing of assets
- making acquisitions or investments
- paying dividends or making distributions to owners
- changing your business activities
If the lender has taken security over your assets (and has registered it on the PPSR), it’s also important you understand how that security interacts with future financing - particularly if you later want to bring in another lender. This is where it helps to understand how the PPSR system works in practice.
4) Financial Covenants (Ratios And Minimum Thresholds)
Financial covenants are the ones that typically involve calculations - and they’re often tested monthly or quarterly.
Common financial covenants include:
- Debt service coverage ratio (DSCR): a measure of whether cashflow can cover repayments.
- Interest cover ratio: whether earnings can cover interest costs.
- Leverage ratio: how much debt you have compared to earnings or equity.
- Minimum cash balance: requiring a minimum amount of cash at all times.
- Minimum net assets / equity: requiring the business to maintain a certain net worth.
Startup note: early-stage businesses can be particularly exposed if covenants are based on earnings (like EBITDA) while the business is still investing heavily in growth. If your revenue is lumpy or seasonal, covenant testing dates can also matter a lot.
5) “Control” And “Key Person” Covenants
If you’re a founder-led business, lenders may include covenants around:
- changes in shareholding or control
- restrictions on major restructures
- requirements to notify the lender if a key founder/director leaves
These covenants can have real operational impact. For example, a funding round, share transfer, or new investor could technically trigger a breach if “change of control” is drafted broadly.
6) Cross-Default And “Material Adverse Change” Clauses
While not always labelled as covenants, these provisions behave like them.
- Cross-default can mean a default under another agreement (like a lease or another loan) becomes a default under this loan too.
- Material adverse change (MAC) provisions can give lenders discretion if something significant negatively affects the business.
These clauses are often heavily negotiated because they can be wide-reaching if left vague.
How Do You Negotiate Loan Covenants Without Derailing The Deal?
You don’t have to accept every covenant exactly as drafted. In many cases, covenants are a starting point - and the final shape depends on the lender’s risk appetite, your bargaining power, and how clearly you can explain your business model.
Here are practical ways to approach loan covenants so you stay bankable and workable.
1) Focus On The Covenants Most Likely To Be Breached
Not all covenants carry equal risk. In our experience, startups and SMEs most commonly trip over:
- tight reporting deadlines
- overly strict financial ratios
- blanket restrictions on new debt (which can block equipment finance, trade finance, or even standard business credit)
- change of control restrictions that accidentally catch a legitimate capital raise
A good negotiation strategy is to identify which covenants are “high likelihood” issues and fix those first.
2) Ask For Realistic Reporting Timeframes (And Define What You’ll Provide)
If the loan covenants require frequent reporting, make sure the agreement is realistic for your finance function (even if that’s you and your accountant).
You can often negotiate:
- longer timeframes (e.g. 20-30 business days rather than 7)
- clarity on format (management accounts vs audited accounts)
- less frequent reporting until certain revenue thresholds are met
3) Negotiate “Cure” Rights And Breach Grace Periods (Where Possible)
Some agreements give you time to fix a breach before it becomes an event of default, but this isn’t automatic or “standard” across all lenders - it depends on the product, the lender, and your risk profile. Where available (or where you can negotiate it), examples include:
- a grace period to deliver late financials
- the ability to inject equity to repair a net assets covenant
- a requirement for the lender to give notice before enforcement (where appropriate)
This can be especially important if your business is seasonal or affected by timing issues (like delayed receivables).
4) Build In “Permitted” Actions So You Can Keep Operating
Many covenants include a concept of “permitted” actions (for example, permitted debt, permitted security, permitted disposals).
This is a practical way to keep the lender protected while ensuring you can still:
- enter normal supplier arrangements
- replace worn-out equipment
- take on small amounts of additional funding for genuine growth needs
If your lender is taking security, it’s also worth understanding who is responsible for PPSR registrations and what information or consents you may need to provide. Depending on your structure and transaction, you may also choose to register a security interest in other contexts (for example, where your business is the party taking security), to avoid priority and enforcement issues later.
5) Make Sure The Underlying Contract Documents Match The Deal You Think You’re Signing
It’s common for business owners to negotiate commercial terms (amount, interest rate, repayment schedule) but treat the legal drafting as “standard”. This is where covenant risk creeps in.
Before you sign, it’s worth getting the full loan documentation reviewed - including the covenants, the default clauses, the security documents and any guarantees - so you’re clear on your ongoing obligations.
Depending on the structure, this might involve a tailored Loan Agreement (or reviewing a lender’s facility agreement) and ensuring amendments are properly documented if anything changes during negotiation.
What Happens If You Breach Loan Covenants?
A covenant breach doesn’t always mean your business is “in trouble” - but it does mean you need to take it seriously and act quickly.
The consequences depend on:
- how the agreement defines the breach
- whether there’s a grace period or cure right (if any)
- whether the breach becomes an “event of default” automatically or only after notice
- how the lender chooses to respond commercially
Common Outcomes After A Breach
In practice, lenders may respond in different ways. Common outcomes include:
- Waiver: the lender agrees not to enforce the breach (often documented formally).
- Amendment: the covenant is changed going forward (for example, adjusting a financial ratio).
- Reservation of rights: the lender doesn’t enforce immediately, but keeps the right to enforce later.
- Default enforcement: in serious cases, the lender may accelerate repayment or enforce security.
If the business and lender agree to change covenant terms, this should be documented properly - often via a Deed of Variation - so everyone is clear on what applies going forward.
Why “Technical” Breaches Still Matter
Some breaches are “technical” (late reporting, missing notice requirements, a ratio breached because of timing). Even then, a breach can:
- reduce your bargaining power in future negotiations
- limit your ability to refinance or raise further funds
- trigger cross-default provisions in other agreements
That’s why it’s worth setting up internal systems early - even simple ones - to track deadlines and covenant testing.
Personal Guarantees And Founder Risk
Many business loans (especially for SMEs) involve directors or founders giving a personal guarantee. This can materially change your personal risk profile, because the lender may have rights against you personally if the business can’t repay.
If a loan includes guarantees, you should be very clear on when and how they can be enforced and how they interact with covenant breaches. This is also a good time to understand the risks discussed in personal guarantees, particularly if the business is still early-stage.
Key Takeaways
- Loan covenants are ongoing promises in your finance documents, and they can restrict how you operate, report, and grow during the life of the loan.
- Most loan covenants fall into clear categories: reporting, positive, negative, financial, and control covenants.
- Startups and SMEs often run into issues with tight reporting deadlines, financial ratios that don’t match growth-stage realities, and restrictions that block normal commercial activity.
- Good covenant negotiation is usually about making obligations clear, measurable, and realistic - and, where you can negotiate them, including cure periods and “permitted actions” so you can keep operating.
- A covenant breach can give the lender significant rights, so it’s important to respond early and document any waiver or change properly (often through a deed of variation).
- If the loan involves security, PPSR registrations, or personal guarantees, your risk profile can change substantially - and it’s worth getting the documents reviewed before you sign.
If you’d like a consultation on loan covenants, negotiating finance documents, or reviewing your loan and security terms, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.
