Debt facilities like loans and credit lines often come with strings attached in the form of covenants. Covenants are promises made by the borrower to take or refrain from certain actions for the duration of the debt facility. Lenders use covenants to mitigate risks and ensure the borrower operates in a way that preserves their ability to repay the debt.
While covenants help lenders manage risks, they can be problematic for borrowers if not properly understood or negotiated. This article will explain common types of covenants, provide examples, discuss negotiating tactics, and cover what can happen if covenants are breached.
The Basics of Covenants
Broadly speaking there are two categories of covenants:
Affirmative Covenants – Promise to take certain actions like providing financial statements, paying taxes, maintaining insurance, etc.
Negative Covenants – Promise to refrain from taking certain actions like incurring additional debt, granting liens, making acquisitions, etc. without the lender’s consent.
Covenants are outlined in the debt facility agreement and applicable for the entire term of the loan unless specifically waived on a temporary or permanent basis by the lender. They tend to be boilerplate from the lender’s perspective but may be customized during negotiations.
Tighter covenants result in closer monitoring and potentially more waivers needed from the lender if the borrower wants flexibility. Looser covenants provide more operating freedom but come with higher interest rates or fees. Finding the right balance is key.
Financial Covenants
Financial covenants focus on the financial health and liquidity of the borrower. They usually involve maintaining certain ratios and metrics within predefined limits.
Common examples include:
Minimum Cash Balance – Requirement to keep a minimum cash balance to ensure funds are available for debt service. Can be structured as an absolute dollar amount or percentage of outstanding debt.
Current Ratio – Divide current assets by current liabilities. Demonstrates short-term liquidity to cover near-term obligations. A typical covenant might require maintaining a ratio > 1.2x.
Debt Service Coverage Ratio (DSCR) – Measure EBITDA against debt obligations due over the next 12 months. Indicates ability to service debt from operating cash flow. A typical DSCR covenant is > 1.25x.
Total Debt / EBITDA – Indicates the number of years of cash flow required to pay off total debt. Higher leverage translates to higher risk. A typical covenant might cap this ratio at 3.0x – 5.0x.
Tangible Net Worth – Measure of equity required to be maintained, defined as assets minus liabilities minus intangibles like goodwill and patents. Used to avoid excessive leverage.
Breaching a financial covenant signals deteriorating financial health and puts the borrower in technical default even if payments are current. It also restricts access to any undrawn funds until cured or waived.
Operational Covenants
While financial covenants focus on dollars and cents, operational covenants govern how the business operates.
Collateral Coverage – If secured by collateral, the facility will require maintaining a minimum collateral coverage ratio against outstanding balances. Declines in collateral value could trigger default.
Dividend Restrictions – Limit payments of dividends, distributions, management fees or other transfers of cash to equity holders so capital remains invested in the business.
Acquisition Restrictions – Prohibit or limit acquiring other companies to avoid substantially altering the risk profile or over-leveraging. Certain sized deals may require lender approval.
Disposition of Assets – Require lender notification or consent before selling material assets leading to declines in collateral value or cash flow.
Change of Control – Require immediate repayment of outstanding balances if a percentage of ownership transfers without lender approval to avoid unexpected risks.
Line of Business – Restrict moving into riskier or non-core lines of business materially different than underwritten.
Operational covenants protect against actions that could impair repayment capacity or increase risks beyond the initial underwriting. They limit flexibility and require close collaboration with the lender on material business decisions.
Reporting Covenants
Reporting covenants require sharing financial statements, collateral reporting, compliance certificates and other information with the lender periodically so they can monitor performance trends and compliance with facility terms.
Types of Reporting
- Monthly, quarterly and annual financial statements
- Accounts receivable and inventory reports
- Accounts payable agings
- Projections and budgets
- Tax returns
- Compliance certificates confirming adherence to covenant requirements
Frequency of Reporting
Requirements typically increase for higher risk loans. For example, monthly for no/low collateral asset-based loans or quarterly for lower risk term loans against real estate assets.
Delivery Method Physical and/or electronic submission. Loan agreements usually outline detailed requirements and timing.
Reporting covenants create administrative burden and oversight but are critical for the lender to monitor trends and risks.
Negotiating Covenants
Covenants should not be taken lightly or left to boilerplate terms. The wrong covenants can severely limit flexibility to operate and grow your business.
Here are some tips when negotiating covenants:
Know Your Numbers – Stress test financial projections and ratios against proposed covenant formulas and levels across multiple scenarios to understand flexibility.
Analyze Historical Volatility – Review fluctuations in working capital, profits and losses over the past 2-3 years to inform appropriate cushions and headroom.
Link Covenants to Plans – Coordinate covenant formulas and levels with budgets and projections to ensure proper alignment and room for error.
Push for Realistic Covenants – Requirements not grounded in reality may signal the deal is structured too aggressively or lender has lack of vision into operations.
Negotiate Ratchets Over Time – Renegotiate covenant formulas and levels over the term if financial performance improves to “earn back” flexibility.
Exchange Covenant Concessions for Pricing Benefits – Seek lower fees or interest rates in return for agreeing to tighter covenants.
While most covenants are negotiable, financial covenants like minimum cash balance and fixed charge coverage ratio tend to be more rigid as they directly protect lenders. Know which covenants matter most before conceding.
Covenant Violations
Despite best efforts, breaching covenants is fairly common over the lifetime of a loan when unexpected events affect financial performance. Roughly 20-30% of companies breach covenants requiring an amendment or waiver.
Declining financial metrics usually signal covenant issues before a technical default happens. Borrowers should proactively address concerns through open communication with transparency into challenges and plans to correct the trajectory.
Upon a covenant breach, several things can happen:
Technical Default – Outstanding debt immediately goes into default status allowing the lender to cease further advances, accelerate repayment timelines and exercise other remedies per loan documents like seizing collateral assets.
Amendment – Lender formally revises covenant requirements to establish a new baseline the borrower can achieve moving forward while default remains in place until amendment is signed.
Temporary Waiver – Lender agrees to temporarily waive the covenant violation while the borrower gets back into compliance, usually under a strict action plan requiring progress reports.
Permanent Waiver – Rarely granted, lender agrees to waive future covenant breaches for the affected metric through loan maturity. Given in extreme situations with mitigating circumstances.
Technical defaults quickly spiral into liquidity crises if not cured. Borrowers lose access to revolvers and term loans to fuel operations while outstanding debt becomes immediately due. Getting a waiver saves the day but requires convincing the lender you have a viable turnaround plan.
Debt Covenants and Venture Capital
Funded startups eventually need leverage for growth capital beyond VC equity rounds. Debt facilities help conserve ownership and match asset-liability timing.
But the strings attached via covenants can constrain hyper growth potential. Negotiations center around balancing risk management controls for lenders with flexibility founders need to scale.
Common areas of focus include:
Permitting High Projected Growth Rates – Provide for exponential growth in covenant ratio formulas given the venture capital model.
Carving Out Large Operating Expenses – Exclude items like R&D, sales & marketing and capital expenditures from ratio calculations to ease compliance.
Funding Operating Losses – Waive or set realistic alternate covenant requirements for projected periods of negative cash flow.
Founders should educate investors on the venture debt process and how restrictive covenants require give and take to land on terms supporting the equity thesis. With the right structural adjustments, covenants can regulate without choking growth potential.
Managing the Lifecycle of Covenants
Covenants often tighten over the loan term as principal balances decline and lenders reduce flexibility nearer to maturity. Amendments and waivers happen frequently as borrowers maneuver dynamic business conditions.
Here is a general timeline for managing covenants over the full lifecycle of a debt facility:
Month 1 – Finalize reporting requirements, submission formats and due dates.
Months 3 – 6 – Develop financial models, analytics and processes for tracking covenant compliance.
Months 6 – 12 – Renegotiate any covenant levels misaligned with actual performance as initial projections and estimates refine.
Months 12 – 24 – Conduct periodic reviews of headroom and early warning indicators across covenant metrics.
Months 24 – 36 – Reassess covenants against current projections and negotiate amendments in advance of potential breaches.
Months 36 – Maturity – Carefully monitor covenant risk and prepare turnaround plans if declining trends emerge. Proactively engage lenders well ahead of maturity.
Covenants that seemed reasonable at origination might lose touch with reality years later. Expect regular renegotiations and planning cycles to keep covenant packages relevant over the full term.
Impact of Recessions on Covenants
When adverse economic conditions cause financial turmoil across markets, virtually all companies suffer impacts trickling into strained covenant compliance. Revenue contractions, margin erosion and working capital fluctuations ?????? aggravating factors outside the control of management teams ??? necessitate a delicate balancing act.
Borrowers navigating volatile business performance during recessionary environments must walk the line between financial prudence and operational investments vital for recovery and growth. However restrictive debt covenants aimed at deleveraging balance sheets could force deep cuts counterproductive to enduring market shifts and emerging stronger afterwards.
Bridging this divide requires financial discipline and operational endurance coupled with proactive engagement between borrowers and lenders:
- Review risks across the customer, supplier and distribution channels along with associated covenant exposures.
- Share frequent performance updates, even mid-period, to provide transparency around operational and financial challenges.
- Detail realistic cash management strategies addressing revenue and margin deterioration – whether reducing inventory levels or extending payment terms with suppliers.
- Outline tactical investments in infrastructure, technology and personnel needed to drive strategic initiatives critical for the next business phase.
- Model various performance scenarios balancing potential covenant defaults against growth prospects over 12-24 month horizons.
During economic expansions, covenant terms center around ensuring borrowed capital fuels growth. But amid contractions, the focus shifts to business preservation. This requires open communication channels understanding how covenants, crafted before turbulence emerged, pressure executives to prioritize near term liquidity over long term prosperity.
While parties certainly protect respective financial interests, lenders desire performing credits warranting modified terms in contrast to defaults. Sincere collaboration aligning covenants with operational realities offers the best avenue for mutually beneficial outcomes.
Frequently Asked Questions
What happens if I miss an operational covenant like providing financial statements?
Missing routine reporting covenants usually triggers a grace period where the borrower receives a default warning from the lender. If the reporting is not brought current by the deadline, the loan goes into technical default allowing the lender to take remedies like restricting cash access or charging higher interest rates.
Do financial covenants adjust automatically over time?
Covenants remain static according to originally negotiated terms unless formally amended. Renegotiating facilities to ratchet covenant levels aligned with performance improvements over the term is common. Auto-adjusting covenants are rare but possible if expressly defined upfront.
Can recurring covenant violations lead to default if we always obtain waivers?
If the borrower never actually goes into technical default by curing violations before the deadline, the loan remains in good standing. However, recurring covenant breaches raise default risk profiles warranting increased oversight and could inhibit future lending capacity even if existing facilities remain compliant.
What constitutes a material change when complying with operational covenants?
Material changes are intentionally undefined, subject to lender interpretation based on risk impacts to their collateral positions. Borrowers should align with lenders upfront on what business alterations require consent by proposing pre-approved thresholds around changes to ownership structures, product mixes, customer concentrations and market expansions plans.
Can personal or corporate guarantees help negotiate room on financial covenants?
Yes, increasing the credit quality of the loan via third-party corporate or personal guarantees provides justification for easing standard underwriting criteria like covenant metrics. However, guarantees come with their own burdens, so judge carefully against giving up operating flexibility.
Key Takeaways
Covenants play vital roles balancing the needs of borrowers and lenders but can become restrictive if not understood or negotiated properly at loan origination. Staying compliant requires financial discipline and operational agility over months or years of unknown business conditions ahead.
While covenant definitions contain complex legal terminology, the objectives boil down to ensuring liquidity, stability and transparency ?????? reasonable goals for any financial partnership. Maintaining open communication channels for renegotiating terms when actual realities veer from projections establishes foundations for mutually beneficial relationships over economic and business cycles.