Covenants, Security and Personal Guarantees: The Three Terms That Matter More Than Your Interest Rate

Most borrowers negotiate the one number that is easiest to compare and sign away everything that actually matters. You will spend three weeks pushing a lender from 11.5 per cent to 10.9 per cent, and then sign a sanction letter containing a DSCR covenant tested quarterly, a hypothecation charge over every current asset you will ever own, a negative lien blocking any future lender, and an unlimited personal guarantee from you and your co-promoter. The 60 basis points you won are worth about 18 lakh over the life of a 30 crore facility. The covenant package you did not read decides whether you keep control of the company in a bad year.

Covenants Are Not Compliance. They Are Repricing Rights.

Founders treat covenants as compliance paperwork. Lenders treat them as options. A financial covenant is a contractual right for the bank to reprice, restrict or recall your facility the moment your performance dips below an agreed line. It is not a warning system. It is a trigger.

Take a common one. A term loan with a minimum DSCR of 1.25x, tested quarterly on a rolling twelve-month basis. Your EBITDA is 12 crore, annual debt service is 9 crore, so you are sitting at 1.33x. That feels comfortable in a board meeting. Run the arithmetic in the other direction: a 10 per cent fall in EBITDA takes you to 1.20x and you are in breach. A single bad quarter in a seasonal business, one delayed receivable from a large customer, one input cost shock. You did not agree to a 1.25x covenant. You agreed to hand the lender a repricing right if earnings fall by more than nine per cent.

Do the same test on every covenant before you sign. Compute the headroom as a percentage move in the underlying driver, not as a ratio. A leverage covenant of 3.0x on 30 crore of debt and 11 crore of EBITDA looks fine at 2.73x. Add 3 crore of capex debt, lose a crore of EBITDA, and you are at 3.3x with no new borrowing capacity and a default on the existing facility. The covenant that constrains your growth plan is usually not the one you argued about. Ask how each term is defined, particularly EBITDA and what is excluded from it, how often it is tested and on what period, and whether a breach carries a cure period or an equity cure right. Quarterly testing on trailing twelve-month numbers gives you four chances a year to fail.

What You Pledged Versus What You Think You Pledged

Security documentation is where borrowers consistently underestimate what they have given. You believe you pledged the plant. You have usually pledged considerably more. A standard working capital arrangement takes a first charge by hypothecation over the entire current asset base, present and future. That is not a fixed pool. It is every rupee of inventory and every receivable the business will ever generate, floating in favour of the lender.

Layered on top is drawing power. Your sanctioned limit is 25 crore, but what you can actually draw is calculated monthly from stock and debtors after margins and after deducting creditors. A slow collection quarter can cut your drawing power to 18 crore while your working capital need is at its peak. You have a 25 crore limit and a 7 crore hole. That is a structural feature of the instrument, not a bank error.

Then look at the clauses that constrain the next transaction rather than this one. The negative lien blocks you from creating any charge in favour of another lender without a no-objection certificate. Cross-collateralisation makes the security for your term loan also secure your working capital, so a default on one contaminates the other. Cross-default clauses extend that across group entities. The consequence is practical: when you go to raise growth debt in eighteen months, your incumbent banker controls whether the transaction happens and on what terms. Push for exclusive charge on assets funded by new debt, carve-outs for identified future facilities, and a defined release mechanism once milestones are met. Security you cannot get released is security you have given permanently.

The Personal Guarantee Is Not a Formality

The personal guarantee is the document founders sign fastest and understand least. Under Section 128 of the Indian Contract Act, 1872, the liability of a surety is co-extensive with that of the principal debtor unless the contract provides otherwise. Co-extensive means exactly what it sounds like. The lender does not have to exhaust the company assets first, does not have to enforce the security first, and does not have to sue the company at all. It can come directly at you, for the full amount, on day one of default.

The enforcement environment has hardened. In Dilip B. Jiwrajka v. Union of India, decided on 9 November 2023, the Supreme Court upheld the constitutional validity of Sections 95 to 100 of the Insolvency and Bankruptcy Code, which govern insolvency proceedings against personal guarantors. Lenders now have a tested route to proceed against guarantors individually, and they are using it. Personal bankruptcy also carries disqualification from holding a directorship. The guarantee is no longer a comfort document that sits in a file.

Three specifics matter. First, quantum: most guarantees are unlimited and cover all present and future facilities, not the one in front of you. Second, duration: guarantees typically survive repayment of the specific loan and continue until formally released in writing. Third, who signs: when a spouse or a non-executive family member is added as a co-guarantor, the household has lost its diversification entirely. Ask whether the guarantee can be capped at a defined amount, whether it reduces as principal amortises, and what triggers release. Many lenders will accept a capped and reducing guarantee, or a dilution once external equity comes in. They will not offer it.

Where the Negotiation Actually Is

Your leverage exists at sanction, not at breach. Once you have signed, the lender holds the options and you are asking for waivers, which are priced. Before you accept the sanction letter, run the covenant package through your own base and downside case and show the lender where it breaks. A credit team confronted with a modelled downside will usually widen headroom, because a covenant that trips in a normal bad quarter creates work for them too.

Do not treat any of this as boilerplate because the format looks standard. The document is standard. Your numbers are not. Negotiate the covenant headroom, the definition of EBITDA, the security perimeter and the guarantee terms with the same seriousness you bring to pricing. Interest cost is a line in your P and L. The rest of the document decides who is in control when the plan does not work.

Disclaimer

This article is for general information only and does not constitute financial, investment, tax, legal, or professional advice. The views expressed are for general informational purposes and should not be relied upon as a substitute for advice specific to your business or circumstances. Please seek appropriate professional advice before making any business, financial, investment, or transaction-related decision.