Negative covenants are the things a borrower promises not to do without the lender's consent while the loan is outstanding: take on more debt, grant liens on its assets, sell significant assets, merge or buy other companies, make investments or loans, pay distributions, deal with affiliates on non-market terms, or change the nature of the business. Each prohibition comes with exceptions, called baskets, that let the business run day to day without asking permission. The prohibitions are mostly boilerplate. The baskets are negotiable, and they should be sized to the owners' actual plans before closing.
- What they are
- Promises not to do things without the lender's consent
- Main categories
- Debt, liens, asset sales, mergers and acquisitions, investments, distributions, affiliate transactions
- How the business gets room
- Baskets: fixed amounts, ratio tests and named exceptions
- If breached
- Event of default, usually with no cure period
- When to negotiate
- Before the term sheet is signed
Why lenders write them
A lender underwrites a business as it stands on the day of closing: its debt, its assets, its owners, its line of business. Negative covenants keep that picture from changing in ways that would hurt the lender without the lender having a say. New debt would compete for the same cash flow. A lien granted to someone else would put another creditor ahead on some of the collateral. An asset sale could remove what the lender relied on. A distribution sends cash to the owners that could have repaid the loan.
Where affirmative covenants keep the lender informed and the collateral intact, negative covenants protect the structure. They are written broadly on purpose: the default position is that nothing is allowed, and then the agreement lists what is. That drafting choice is what makes the baskets so important.
The standard restrictions
| Covenant | What it restricts | Common baskets that give room |
|---|---|---|
| Indebtedness | Borrowing money, guaranteeing others' debt, capital leases | Existing debt listed on a schedule; equipment loans and capital leases up to a set amount; a general basket; debt allowed if pro forma leverage stays under a stated level |
| Liens | Granting security over any asset to anyone but the lender | Liens securing the permitted equipment debt (purchase-money liens); tax and statutory liens not yet due; deposits for leases and utilities; a general basket |
| Asset sales | Selling, leasing or transferring assets outside the ordinary course | Sale of inventory in the ordinary course; worn-out or surplus equipment; sales up to an annual amount, often with proceeds used to repay the loan |
| Fundamental changes | Mergers, consolidations, liquidations, changes of legal form | Mergers of subsidiaries into the borrower; permitted acquisitions |
| Acquisitions and investments | Buying companies, investing in or lending to other businesses, forming subsidiaries | Permitted acquisitions meeting stated conditions; cash equivalents; loans to employees up to a small amount; a general investment basket |
| Restricted payments | Dividends, distributions, buybacks, payments on subordinated debt | Tax distributions for pass-through owners; a fixed annual amount; payments allowed while leverage is under a set level |
| Affiliate transactions | Deals with owners, relatives and companies they control | Transactions on terms no worse than arm's length; ordinary compensation; listed existing arrangements such as a lease from the owners' real estate company |
| Change of business | Moving into a materially different line of business | Businesses reasonably related to the current one |
| Other | Amending subordinated debt or seller notes, sale-leasebacks, changing the fiscal year, restrictive agreements, granting liens to others (a negative pledge) | Case by case |
Several of these have their own pages. Restricted payments covers distributions in detail. Negative pledge covers the promise not to grant liens to anyone else, which unsecured lenders rely on. Change of control is usually an event of default rather than a negative covenant, but it limits the same thing: who owns the business.
How baskets work
A basket is an exception with a limit. Lower-middle-market agreements use four kinds, often side by side in the same covenant.
- Named exceptions. Specific items listed on a schedule at closing, such as the existing equipment loans, the lease from the owners' real estate entity, or a seller note on agreed subordination terms. Anything not on the schedule is not covered, so the schedule must be complete.
- Fixed-amount baskets. A dollar limit, either outstanding at any time (debt, liens, investments) or per year (asset sales, distributions). Simple and predictable; they do not grow with the business unless the agreement says so.
- Ratio-based baskets. The action is allowed if, after it, a ratio such as total leverage would stay under a stated level. These are incurrence tests. They give a growing business more room over time but close when earnings fall.
- Conditional baskets. Permitted acquisitions are the common example: allowed if the target is in a related business, the purchase price is under a cap, no default exists, the business is in pro forma compliance with its financial covenants, and the lender receives the target's figures and a lien on its assets.
Most baskets also carry a general condition that no default exists at the time. That means a business in covenant trouble often loses its baskets at the moment it most needs flexibility, which is one more reason to keep headroom on the financial tests.
A worked example: the equipment basket
A manufacturer's term loan allows other debt of up to 500 for equipment financing, plus a general basket of 250 for anything else. The owners plan to replace two machines next year, costing 900, and would like to finance them with the manufacturer's own finance program at a better rate than the term lender offers.
The equipment basket holds 500, and a small forklift lease already uses 120 of it, leaving 380. The general basket could take another 250, for 630 in total. The machines need 900. The business is 270 short, so it can either pay the balance in cash (which, on a fixed charge coverage test, counts as unfinanced capital spending), delay one machine, or ask the lender for consent.
Had the owners shared their equipment plan before closing, the equipment basket could have been sized at 1,200 with no real cost to the lender, since each machine carries its own purchase-money lien and does not touch the term lender's other collateral. After closing, the same change needs an amendment, and possibly a fee. See equipment loans alongside senior debt for how lenders usually handle this.
Every basket is a forecast. Size it from the business plan, not from the lender's form.
What happens if one is broken
Breaking a negative covenant is an event of default, and unlike many affirmative covenants it usually has no cure period. The reasoning is that the borrower chose to act: it signed the lease, granted the lien or paid the distribution, and cannot simply undo it by delivering something late.
Many breaches are innocent. An owner signs a vehicle lease in the ordinary course, not realizing it counts as debt. A supplier's credit application includes a security agreement, and the supplier files a UCC-1 against inventory, which is a lien. A company pays an owner's personal expense and books it as a loan to the shareholder, which is an investment in an affiliate. Each one may be small, but each one is a default until the lender waives it, and each can trip a cross-default elsewhere.
The fix, when it happens, is to tell the lender and ask for a waiver before it is found. Lenders routinely waive small, well-explained breaches. They are less forgiving of ones they discover at a field exam or a lien search.
What to negotiate before signing
The prohibitions themselves rarely move. The baskets and conditions do, and the time to move them is the term sheet, when the lender is competing for the loan. A short list of what the business expects to do over the loan's life is the best negotiating tool:
- Equipment and vehicles to be financed, and whether by lease or loan.
- Acquisitions under consideration, their likely size, and whether they would be financed by this lender. See add-on acquisition financing.
- Distributions beyond taxes, and when the owners would want them.
- Transactions with the owners: the property lease, shareholder loans, management fees to a holding company. See shareholder loans and lenders and propco-opco structures.
- Assets that might be sold, such as a surplus building or a small division.
Transparent builds that list into the lender package: the model carries the equipment plan, the distribution policy and any planned acquisitions, and the term sheets are compared on whether their baskets fit it. Lenders differ widely here, and a slightly higher rate with baskets that fit the plan is often cheaper than a lower rate that needs three amendments.
Common questions
- What is a basket in a loan agreement?
- An exception to a negative covenant, with a limit. It lets the business take a restricted action, such as borrowing for equipment or paying a distribution, up to a fixed amount, under a ratio test, or on stated conditions, without asking the lender.
- Is an equipment lease debt under a negative covenant?
- Usually yes if it is a capital or finance lease, and the agreement's definition of indebtedness decides. Many agreements have a specific basket for equipment financing and capital leases. Check before signing.
- Can I still buy another company with a term loan in place?
- Only within the acquisition basket or with the lender's consent. Permitted-acquisition baskets usually cap the price and require no default, pro forma covenant compliance and a lien on the target's assets.
- Do negative covenants have cure periods?
- Usually not. Because the borrower chose the action, most agreements treat a negative covenant breach as an immediate event of default. The practical remedy is a waiver from the lender.
- Do SBA loans have negative covenants?
- Yes. SBA lenders' loan documents restrict additional debt, liens, distributions and changes of ownership, and SBA rules add their own, such as the requirement that a standby seller note receive no payments for the life of the SBA loan.