Introduction

In business contracts, a “covenant” is a formal promise that one party makes to either perform a specific action or avoid doing something. These promises can come in two flavors: restrictive covenants, which stop a party from doing certain things, and affirmative covenants, which require a party to take specific actions. Covenants are key to defining what each side can and can’t do, helping to maintain clear expectations and responsibilities.

Let’s explore what covenants are, why they’re important in business contracts, and how they can affect your deals.

Why are covenants important?

Covenants are important in contracts because they set clear expectations for both parties, which helps maintain smooth business relationships and avoid disputes. Here’s why they matter:

1. Defines responsibilities: Covenants spell out exactly what each party should or shouldn't do, reducing any misunderstandings about who is responsible for what.

2. Controls risk: By specifying certain actions to take or avoid, covenants help protect both parties’ interests and minimize potential risks.

3. Provides a safety net: A well-written covenant gives you a solid basis to act if the other party doesn’t hold up their end of the deal, whether through enforcement or seeking legal remedies.

Types of covenants in business contracts

• Restrictive covenants: These are promises not to do certain things. For instance, a non-compete clause in an employment contract is a restrictive covenant that stops an employee from joining a competitor for a specific time after they leave the company.

• Affirmative covenants: These are promises to take certain actions. For example, in a loan agreement, an affirmative covenant could require the borrower to keep certain financial ratios in check or regularly submit financial reports to the lender

Example of a covenant in a business context

Suppose your business takes out a loan to expand. The loan agreement might come with several covenants. An affirmative covenant could require your company to keep a minimum amount of working capital, ensuring you have enough cash for daily expenses. Meanwhile, a restrictive covenant might prevent you from taking on more debt beyond a set limit without getting the lender's permission.

If you break these covenants—like by borrowing too much or not keeping enough working capital—the lender might have the right to demand full repayment immediately or hit you with penalties.

How understanding covenants can help you

Understanding covenants and how they function can help you negotiate contracts better and avoid accidentally breaking the terms. Before signing a contract carefully review any covenants, understand what they mean, and make sure you can fulfill their requirements. If anything is unclear, consult a legal professional to steer clear of expensive errors.

Conclusion

Understanding covenants and how they function can help you negotiate contracts better and avoid accidentally breaking the terms. Before signing a contract, carefully review any covenants, understand what they mean, and make sure you can fulfill their requirements. If anything is unclear, consult a legal professional to steer clear of expensive errors.