Venture Debt: Let’s Talk Covenants, Part I
There’s no way to talk about venture debt without bringing up the notion of financial covenants. The simple mention of the word “covenant” evokes a connotation of doom and fear in the hearts of many entrepreneurs and equity investors alike - perhaps in part caused by horror stories of overzealous lenders using a covenant trip to invoke remedies (read: sweep cash or foreclose on assets) which led to the demise of a company. While there are certainly exceptions which prove the rule, the vast majority of debt deals which contain covenants don’t lead to such a disastrous outcome. A proper understanding of the way covenants may impact a debt deal is an imperative which deciding how (and if) to pursue venture debt.
(For the purpose of this post we’ll focus on financial covenants related to performance levels or minimum financial standards required of a borrower. It is typical for debt deals to contain other “negative covenants” (i.e. things the Borrower won’t do, such as take on additional debt or allow additional liens on collateral), but in the interest of clarity we will focus on the financial covenants.)
At the very basic level, covenants are used by a lender as a mechanism for mitigating risk by setting parameters of minimum performance/financial condition that the lender is comfortable with at the outset of a deal. While I downplayed the negative connotation of covenants a bit above, the reality is that covenants are indeed a big deal, because a violation of a covenant gives the lender a legal right to enact remedies which may be counter to the desires of management. While covenants typically get the bad rap, they only point towards the bigger reality – taking on debt is a big decision that should not be taken lightly. Using venture debt usually means giving up a blanket lien on all assets (and sometimes intellectual property). Therefore, when there is an issue with a debt provider, literally the entire company’s future hangs in the balance.
With so much to lose, why would anyone employ venture debt, especially in a start-up? The exchange works quite well, in most cases, because of the ability of specialized lenders to create structures which avoid the “worst-case” scenario and the relationships within the industry and implicit contract between lenders and venture capitalists which helps to shape rational decision-making by all parties. Venture debt works best when everyone understands the perspective of the others around the table and there is a mutual dialogue which helps to align the interests of all parties. It may seem counterintuitive but my ideal customers are those who are initially scared silly by the idea of covenants and thus take the structure very seriously – I find that these customers are the most prudent and financially responsible; and when things don’t go as planned, they are swift to react and communicate prior to a covenant trip, allowing for a clean resolution.
Financial covenants can take all different shapes and forms but the most common are either performance covenants or metrics which require certain base levels within the company’s balance sheet. Smart lenders attempt to structure covenants which not only track the company’s performance to plan, but also tie directly into the metrics the equity investors are tracking when considering additional investment. The specific metrics may change over time – for instance, for an early stage company (pre-revenue or very early stages of revenue traction), the focus of the Board may be on growing users, revenue, monthly recurring revenue, or bookings, each of which could be a potential covenant for the lender to track. Another popular performance covenant is EBITDA, as it implicitly captures the top line while also ensuring that expenses (and burn) are not way out of line with revenues. Performance covenants are typically set at a discount to the company’s Board approved plan and measured monthly or quarterly.
Typical balance sheet covenants include standard financial ratios – Liquidity Ratio, Quick Ratio, Current Ratio, Debt/Equity, or Debt Service Coverage. For companies which are using debt to bridge to a next round of equity, a covenant which ties in to both performance and the balance sheet is a remaining months of cash requirement - lenders will sometimes track the company’s burn and require a term sheet or commitment from investors before allowing the company to fall below a minimum level of cash.
A final category of covenants is custom numbers which make sense for a specific business model or stage. For instance, in SaaS companies or models with a strong reliance on monthly recurring revenue, it’s not uncommon to see a covenant tracking churn, as this is a leading indicator of overall performance.
As a matter of practical advice for companies negotiating venture debt, the discussion around covenants should be open and transparent between company and potential lender. The best covenant structures are those which align naturally with the stated goal of the company– for instance, an EBITDA covenant which is set at a discount to the company’s plan but forces towards eventual profitability at the end of the year if that is the goal of the Board. When setting specific performance levels, agree on levels which work for both sides and avoid a situation in which there is so much front end negotiation that the covenant level ends up being set at a level where there is no choice for the lender but to act swiftly to preserve capital.
It’s important to remember that lenders do not extract any great joy in invoking remedies after covenant defaults (in spite of what the horror stories may say). Covenants are a necessary means for mitigating risk for lenders that don’t have any other means of driving behavior. Though the lender has a first position lien on assets, this is typically a passive position with much less ability to affect overall decision than the equity holders or management who sit on the Board. Covenants are a mechanism for setting inflection points to address concerns, and are often the method by which a debt deal is able to remain on track by dealing with the issues at hand rather than letting them spin further out of control.
It should be noted that not all debt deals contain covenants. While covenants are very often found in venture bank deals, transactions with venture debt funds do not typically carry as stringent a structure and there are certainly venture debt deals without any defined covenants. In the next post in the series, we will examine the remedies available to a lender when there is a covenant breach and the pros and cons of having a deal with covenants.
