Affirmative covenants require borrowers to take certain actions such as providing financial statements, complying with tax and other laws, and maintaining adequate insurance. Negative covenants limit actions that borrowers can take without a lender’s permission such as borrowing additional capital, paying dividends to shareholders, selling significant assets, or other actions that may affect collateral or the ability to repay the loan. Because financial covenants are of a less boiler-plate variety and are typically more impactful to the operations of the business, they will be the focus of this piece.
The covenant package is one of the most important aspects of a loan for any borrower to understand and consider prior to partnering with a lender. The approach to financial covenants varies greatly among venture lenders and can be loosely categorized in order of stringency from no-covenant, to covenant-lite, to more standard covenant packages.
While exceedingly important, covenants are just one set of requirements that should be considered holistically along with the rest of the terms of a loan. While borrowers tend to prefer fewer and looser covenants, that approach may make sense, all else being equal. However, lenders tend to consider loans without covenants to add an extra layer of risk to the credit and seek to compensate for that risk with a higher return. Borrowers should also consider factors other than the contractual terms contained within the four corners of the credit agreement.
While covenant-lite or no-covenant loans can sound appealing to a borrower, financial covenants play an important role for the companies that we partner with. Covenants are crucial for aligning expectations of all stakeholders, including management, the board of directors, equity investors, and the lender. Financial covenants set parameters, or guardrails, around the business operations that are mutually agreeable to the stakeholders. Covenants are formulated using a multi-year business plan that reflects expectations for topline growth while managing to a certain level of operating expenditures. Financial covenants help build consensus around the operational plan for the business over the coming quarters and years.
The most common financial covenants found in venture debt agreements are structured around revenue, EBITDA, and cash or liquidity. While the minimum cash covenant may fluctuate or step down over time, the most frequent practice is to set a minimum cash level that must be maintained at all times throughout the life of the loan. On the other hand, performance-based covenants will be set at levels that reflect the minimum expected revenue and/or EBITDA for a given measurement period, be it the trailing quarter or trailing twelve months.
Setting financial covenants is a process unto itself and is another reason why including covenants with a loan is important and constructive. Not only do covenants align expectations, but the process of setting the appropriate levels affords the borrower and lender the opportunity to better understand each other and test their ability to work collaboratively on opposing or contentious issues. The process can also serve as an important signal for the borrower as to how well their lender truly understands their business and industry, and how willing their lender is to be flexible when necessary. The iterative nature of the process benefits both parties by providing opportunities for learning and dialogue. The additional communication will help the lender to even better understand the needs of the borrower and the drivers of their business.
Most financial covenants are set at 20%+ below levels reflected in the base case business model to allow for forecasting uncertainties and inevitable fluctuations in business outcomes that are not necessarily reflective of performance, such as macro forces outside of management’s control. If the borrower fails to meet covenant levels, it usually indicates that the business is not executing to the stakeholders’ expectations, regardless of the root cause(s).
A covenant miss is an invitation for the stakeholders to come together to examine the factors that contributed to the underperformance relative to plan. It requires a healthy reflection on the state of the business and forces a discussion about what changes to the business, if any, should be implemented.
While entrepreneurs tend to be eternal optimists, lenders tend to be much more focused on risk and potential downsides. These polar opposite lenses, when combined and focused inwardly on the business, can be a potent force for understanding the drivers of the missed expectations. Identifying the drivers of underperformance is necessary for enacting changes that will ultimately improve the business and lead to better outcomes for all parties. This exercise enables a resetting and realignment of expectations amongst the stakeholders to reflect the current environment, condition of the business, and any other changes since the loan was underwritten.
Understanding your lender’s approach to covenants and how to go about setting appropriate financial covenant levels is such a critical aspect to starting a relationship with a lender that we explore demystifying the covenant setting process in a separate piece.