Venture Debt | Aug 21 2020
12 Questions Answered About Debt Covenants
Do you have a question about debt covenants?
In an interview, I asked Fuse Capital’s Director of Lending Russell Lerman and Analyst Dominic Walter to explain what debt covenants are and what they mean to tech businesses.
Let’s dive in:
What is a debt covenant?
RL: A debt covenant requires a borrower to adhere to contractual rules in the form of specified actions or conditions in a loan agreement.
DW: Typical debt covenants include:
- Cash covenants: A request for a percentage of the outstanding loan balance to be kept in the company bank account.
- EBITDA/forecast covenants: Here, a loan is agreed against a forecast. And the loan recipient or borrower is expected to deliver in line with the estimates, with usually a 10-20% variance.
What is the difference between a positive and a negative debt covenant?
RL: A negative covenant is restrictive. For example, a company is told it cannot take additional debt.
DW: Whereas a positive covenant is an obligation to do something. For instance, a lender might ask a borrower to retain a cash balance equivalent to a percentage of the outstanding balance.
Why do lenders use covenants in lending agreements?
RL: Lenders use covenants to keep borrowers within a certain level of risk.
Covenants help lenders to monitor loans. In particular, a lender can see if a borrower is keeping on track with forecasts and is spending its money as intended.
DW: Elsewhere, covenants act as an early warning signal of a company getting into trouble.
Are covenants similar/different to securities?
RL: Securities will take the form of pledge against the company assets.
If a company is put into Administration, a lender can get its money back by realising or selling its securities.
DW: On the other hand, covenants are used to monitor loans. Contractually speaking a lender can “recall” a loan if a covenant is triggered.
However, if a breach is periodic, lenders tend to work with the borrower to resolve the issue.
Why is this topic important for tech companies?
RL: It’s essential for all companies to understand covenants. However, it’s probably more critical for high growth businesses, which tend to be tech companies.
The reason being is that traditional more mature businesses tend to be stable in terms of business model, revenue, profit etc., whereas tech companies are on a slightly less linear path. This path can lead to breaching covenants.
Why do tech companies worry about covenants?
DW: Tech companies invest heavily in Intellectual Property (IP), so when a lender becomes the senior creditor in the event of a default, this poses a significant problem.
However, the level of ‘worry’ can be managed by understanding the risks and mitigations.
What happens when debt covenants are violated?
DW: When a covenant is breached, a lender has the right to recall its loan (ask for full repayment) and push a borrower into Administration.
RL: Clearly, it’s not in a lender’s interests to take such drastic action. So unless a company is in significant distress and is unlikely to be saved, lenders work with management to see how and when they can get a company back on track.
Do private debt funds issue covenants?
RL: Some do, and some don’t.
How is it that the covenants issued by private debt funds are ‘lighter’ than those issued by conventional debt financiers?
RL: It all comes down to underwriting.
Whereas bank lenders cannot see finance opportunities outside of traditional net debt EBITDA ratios, a private debt fund is likely to have specialisms in the tech sector and more importantly understand your business model.
Because of its understanding, it underwrites on the quality of your business plan, revenue streams, and capital strategy.
DW: And unlike asset-based finance which secures loans on collateral in the form of fixed assets, a private debt fund can leverage your intellectual property assets as security.
How did private debt fund finance come to be?
RL: There is a long history. But it came to fore after the financial crisis, when the banks stopped lending. Non-bank institutions set up to fill the gap.
What types of companies are eligible for private debt funded finance?
RL: Private debt funds will consider all companies for debt finance.
How do tech companies benefit from a private debt fund approach to underwriting debt finance deals?
RL: It’s simple. Conventional banks can’t support growing tech businesses. And debt is cheaper than equity.
DW: Because private debt funds understand the tech business model, they’re ideally placed to help tech companies boost cash reserves to extend their cash runways.
Also to support growth when a tech company has a roadmap for profitability but isn’t ready to raise funds in a further equity round.