The most common covenants in SME acquisition financing: (1) Leverage covenant: Net Debt/EBITDA must remain below a ceiling (typically 4.5–5.5× at closing, stepping down annually). (2) Interest cover: EBITDA/Net Finance Charges must exceed a floor (typically 2.5–3.5×). (3) Capex covenant: annual capital expenditure cannot exceed a defined level without lender consent. Covenants are tested quarterly or semi-annually; a breach gives the lender the right to demand immediate repayment.
Covenant headroom is critical in post-acquisition planning. If EBITDA is €2m and Net Debt is €8m (leverage 4.0×) against a covenant of 4.5×, the headroom is only €500k of EBITDA decline before breach. A buyer who models tight covenants must plan either a capital injection reserve or a careful acquisition price to ensure sufficient headroom in downside scenarios.
For sellers in LBO transactions, understanding the buyer's covenant package helps calibrate how aggressive their earnout or deferred payment demands can be — additional obligations on the business post-closing consume the same cash that funds debt service. A seller asking for a 30% earnout on top of an already leveraged structure should understand the mechanics of how that earnout will be funded.
Covenant headroom calculation
Acquisition debt: €9m at 6% interest. EBITDA at closing: €2.5m. Leverage at closing: 3.6× (well within 4.5× covenant). Interest cover: 2.5m / 540k = 4.6× (well within 3.0× floor). Headroom: EBITDA can decline to €2.0m before leverage covenant breaches (€9m / 4.5× = €2.0m). This 20% EBITDA buffer is the buyer's margin of safety.
Frequently asked questions
What happens when a bank covenant is breached?
Technical breach triggers the lender's right to demand immediate repayment (acceleration). In practice, lenders usually grant a waiver or agree to a covenant reset in exchange for an amendment fee and tighter terms — but only if the breach is temporary and the borrower communicates proactively. Silent breaches, discovered in quarterly reporting, lead to significantly worse outcomes.
Do bank covenants affect the seller post-closing?
Only if the seller has deferred consideration (vendor loan, earnout, or escrow). If the business breaches covenants, the lender's right to control cash flows takes priority over deferred seller payments. Sellers providing vendor financing should negotiate inter-creditor protections — or at minimum understand the covenant package before agreeing to deferred payment terms.
What is a covenant-lite structure?
Covenant-lite (cov-lite) loans replace financial maintenance covenants with incurrence covenants — conditions that only apply if the borrower takes a specified action (new debt, dividend, acquisition) rather than tested quarterly. Cov-lite structures are common in large leveraged finance markets but rare for French and Swiss SME acquisition financing, where banks typically require full financial maintenance packages.