The Debt Covenant: Is This Mechanism Right for Your Business?

debt-covenantThere are many terms and financial mechanisms involved in venture debt financing, one of which is a debt covenant. This is one of the loan conditions you may be required to accept to receive venture debt financing. At first, this might give you pause — but a debt covenant is less of a risk to you as a borrower and more of an agreement between both parties.

Both sides of the table want to ensure success, and a debt covenant is an agreement that keeps everyone on the same page and moving toward the same goal. For a lender, that means providing working capital to help you accelerate and achieve your goals. For you, it means gaining those funds and applying them to objectives that produce positive results.

For comparison, mortgages have similar mechanisms. When you buy a home, your loan has requirements that must be upheld, such as maintaining the condition of the home, living in the home as a primary residence, and of course, maintaining timely repayment. When those obligations aren’t met, the lender can take action. The same goes for venture debt covenants.

What Do Debt Covenants Require from Borrowers?

Debt covenants can include any number of criteria that a SaaS borrower would be obligated to uphold throughout the relationship. Typically, these requirements are focused around performance. Naturally, the lender wants to ensure that your business is making progress, using the funds as intended, and demonstrating growth.

Some of the most common requirements include maintaining a certain monthly recurring revenue figure or increasing it incrementally. Another is obtaining a certain number of new subscribers to your platform. Some lenders may also want you to keep your burn rate and customer churn below a certain figure. You’ll see how these are connected and can influence one another, but that doesn’t mean more than one will be required.

The terms of the covenant are typically evaluated on a monthly or quarterly basis. Ultimately, the terms are intended to mitigate risk for the lender and motivate the borrower. However, sometimes circumstances change, perhaps causing you to fall behind a certain metric. This is called “tripping” the covenant. These things happen, and often, lenders are willing to work with you to help you get back on track.

But just as a lender leaves little to chance, so too must you as the borrower. It’s important to understand the risks of tripping a covenant — particularly if the trip is more than just a small incidental fumble — so you know what the lender is legally permitted to do in that situation.

The Risks of Tripping a Debt Covenant

When you’re unable to meet the requirements of a covenant, your lender has the ability to take a number of remedying actions. Again, lenders don’t necessarily want to throw in the red flag right away. It’s to everyone’s advantage that you keep moving forward. But, they may call a timeout to help you re-establish your game plan.

In the event that you tripped a covenant beyond what the lender is comfortable with, they may enact certain terms of the covenant. A common yet still concerning action lenders can take is restricting access to additional credit until the problem is resolved. They may also be able to increase the rate on your loan — not just once, but repeatedly until you’re back on track. While there are caps on the amount the rate can increase by, as we all know, even small adjustments to rate can translate into significant dollar amounts over the course of the loan.

Perhaps the harshest step a lender can take is to declare your loan due at the time of the trip. This is an extreme step and, depending on whether you can access other capital or liquidate assets, could lead to a situation in which you may not be able to repay the debt and continue operating the company.

Should You Work with a Lender that Uses Covenants?

Just as with warrants, not all venture debt lenders require covenants as part of a loan agreement. They’re often negotiable, too. Covenant terms may be set by the lender as part of the arrangement, and you’d have to agree to them. More likely though, you’ll be a participant in the development of the terms of the debt covenant.

Remember that a covenant is a form of aligning interests and progress. The existence of a covenant in your loan terms is not a bad thing. As a borrower, you can think of it as a guide. “This is what’s expected in exchange for the investment,” and if you agree to it, it can motivate you and provide a north star for your organization and plan to follow.

And remember, tripping a covenant doesn’t mean it’s game over. Your lender will work with you, perhaps even providing a waiver or working with you to restructure the deal. But when you trip a covenant, you signal to the lender that more risk has entered the game, and that’s something they’ll be watching for in the future.

If you have questions about covenants or would like to learn more about the flexibility that debt financing can offer, we’re here to help. Simply fill out the form below to speak with a member of our investment team. We’ll be happy to answer any questions you have.