At SWK, we believe that financial covenants and the process of setting mutually agreeable covenant levels play an important role in the lender/borrower relationship. A lender’s willingness to engage in the discussions and accommodate the requests outlined herein can be an instructive behavioral signal for any borrower. Further insights into why financial covenants should not be viewed by borrowers as universally negative can be found here.
During the covenant-setting process, both parties are able to communicate their needs and engage in constructive dialogue about which operating metrics are ideal for measuring the borrower’s performance and execution. The borrower’s management team should use the opportunity to explain nuanced drivers of their business and areas for potential flux in the financial model to help elucidate what they view as appropriate covenant levels for their specific business. This discussion will demonstrate not only a lender’s willingness to listen to the borrower’s concerns and incorporate them into solutions, but also how deeply the lender understands the borrower’s business and industry niche. Experienced lenders understand the need to balance providing an appropriate cushion with covenants that are tight enough to capture material underperformance before the root cause metastasizes beyond redress.
In venture debt, covenant breaches are inevitable. A quality lender should be willing to discuss both its general and specific approaches to curing covenants with borrowers. Hence, prospective borrowers should not shy away from discussing how their lender has historically handled covenant breaches with portfolio companies. Covenant breaches may indicate that the level of inherent risk in the business has escalated since loan origination and certain financial or other penalties should be expected to compensate for the elevated risk. While some form of consideration from the borrower should be anticipated, beware of lenders that seize on the opportunity to meaningfully rewrite the economics of the deal, particularly for minor breaches.
For better insight into a lender’s specific approach to resolving covenant breaches, a borrower may consider asking the lender for a copy of a redacted (borrower-specific information removed) amendment from a portfolio company that breached financial covenants. This document will reveal how the lender managed the breach and what fees or penalties were assessed. A word of caution: early-stage companies and their growth trajectories are exceedingly idiosyncratic. Thus, covenant breaches are often of varying magnitudes and are the result of unique causes. Consequently, they require bespoke resolutions. Prior amendments should be viewed as merely illustrative, as the particular circumstances surrounding the breach can be substantially more important than what is reflected in the terms that are codified in the legal documentation.
To better understand the role the human element plays in curing breaches, it may be most instructive to request a reference call with a portfolio company that has navigated the covenant breach process with the lender. Most quality lenders should be willing to arrange a conversation with such a borrower. The conversation will help add color and context, but in light of the aforementioned idiosyncrasies, understanding whether the lender acted rationally and collaboratively as viewed through the eyes of an experienced borrower may be more valuable than ascertaining the specifics of any one instance of breach.
Prospective borrowers may also inquire about the number of amendments the lender has executed with its most challenged borrower. While all venture lenders attempt to underwrite loans of exceptional quality, the need to amend credit agreements for covenant breaches is inevitable and lenders likely have a borrower or two that has required an outsized number of amendments. Multiple amendments with a single borrower demonstrate the lender’s willingness to work through issues with borrowers rather than resort to draconian measures. Choosing a lender that is an expert in the borrower’s industry mitigates the risk of partnering with an inexperienced lender that may be inclined to overreact when a covenant is missed.
Finally, borrowers may want to discuss pre-defined cure options for covenant breaches. This may be the most controversial recommendation as not all lenders are amenable to pre-determined contractual cures. Further, lenders that are amenable may set restrictions such as only allowing for a certain number of cures throughout the life of the loan. While cures provide for contractual certainty of outcome and peace of mind for the borrower, they can impede on the important function of critical reflection and the strategic pivots that covenant breaches induce. Resolving a covenant breach post-hoc is an important exercise for analyzing risks and for enacting changes that put the company on more solid footing and result in better outcomes for all parties involved.
Since setting covenant levels can be equal parts art and science, we find that an iterative process tends to produce the best outcomes. Borrowers should keep in mind that there are no “right” covenant levels, but rather levels that both sides can agree are satisfactory for achieving their respective goals. Negotiating specific covenant levels is not only expected but welcomed by lenders. While a lender will attempt to suggest what it believes to be appropriate covenant levels, thoughtful input from management based on their experience and expertise can be invaluable. Understanding these points and employing the strategies outlined above should help ease the concerns that borrowers naturally feel towards covenants.