Debt Covenants Explained: A Guide for Startups
- Lighter Capital
- Jan 10, 2023
- 5 min read
Updated: Feb 20, 2024
A covenant, by definition, is a type of agreement often found in contracts that obligates one or more parties to either engage or abstain from some specific action. Covenants are unconditional promises that, when breached, entitle the other contracting party to damages, remediation, or termination of the contract.
If you’ve ever signed a contract of any kind, you are likely already familiar with the idea that covenants are usually "baked into the agreement." A contract stipulates a lot of details, including what the signatory is committing to do and not do — often using words such as “agree” or “promise.” Most commonly, businesses encounter covenants when borrowing money, in agreements detailing what's being promised in exchange for a loan.
These promises, known as debt covenants, can be as simple as, “I agree to be profitable,” meaning you have to be positive net income; or covenants can be very specific like, “I promise to maintain a minimum of $100,000 cash-on-hand at all times.”
Before you sign any loan contract, get familiar with the types of debt covenants you might encounter and what you should look out for in startup financing agreements.
What is a debt covenant?
Debt covenants, also referred to as financial covenants, banking covenants, or loan covenants, are conditions set forth within financial contracts (such as loans and bonds) in which the borrower is either obligated or forbidden to undertake a specific action.
Lenders typically use debt covenants as a means of ensuring that a borrower maintains their business in a way that will make the loan payment most likely. It’s a way that lenders can micromanage borrowers to attempt to mitigate risk — a form of “guardrails” that lenders can set up to ensure a business is staying well within a margin of error in its operations.
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Types of Debt Covenants
Debt covenants are categorized as either positive or negative:
Positive covenants
A positive covenant is an obligation to do something — “you shall.”
Negative covenants
A negative covenant is a promise not to do something — “you shall not.”
Be cautious of restrictive debt covenants
Negative covenants are also referred to as restrictive covenants because they limit what actions you can take, and that can create new challenges when you're running a startup. You probably did not need another one of those!
Debt covenants are inherently risky for borrowers, and even more so if the covenants are restrictive. It can be easy to accidentally run afoul of overly restrictive covenants, and even those that are easy to meet may be artificially constraining in ways that limit your ability to take creative or bold action.
How do debt covenants work?
A debt covenant lays out the conditions the borrower must fulfill, or the actions they must avoid, to remain in good standing with the lender.
Covenants run the gamut from the basics of business operations, such as maintaining the business and running it in a legal manner, to more specific and complex requirements. Many covenants are financial, like specifying the need to maintain a certain growth rate, a minimum amount of runway, or keeping your cash balance in the bank above a minimum.
If a business has unexpected churn, spends money in the wrong place, or struggles to collect payments from customers, the business could temporarily breach a covenant with a lender. Even if a financial covenant breach seems miniscule, it's still a violation.
At that point, the borrower usually gets anywhere from seven through 30 (or maybe as many as 45) days to resolve the problem. After that, it’s up to the lender to decide how they will handle the situation to recoup their costs and get their principle back.
Debt covenant violations: What happens if you breach a covenant?
Various penalties may result when a borrower violates a debt covenant. Resolution of the penalty often depends on the lender and the borrower's relationship with the lender:
In the best case scenario, the lender and borrower sit down together as partners to try to understand the problem and figure out how to solve it.
If the lender isn’t so accommodating, they may declare default on the loan, apply penalties, or call the loan — that is, demand that it be paid in full right away.
Are debt covenants bad for startups?
Debt covenants can be overly restrictive, and in that case there’s a real possibility that a young, growing business will breach one unintentionally. Startup leaders should think really hard about what it would take to breach one of the covenants in a contract they’re about to sign.
If violating a debt covenant seems well within what's plausible, be wary!
In a worst-case scenario, you could make a single misstep that breaches a debt covenant, and if you can't pony up the full loan amount, you might lose control of your startup entirely.
Even if a business is not in real danger of breaching a covenant, the conservative boundaries imposed by restrictive covenants can easily box-in founders, forcing startups to operate in ways that hinder their growth.
Just like startup equity dilution, it all comes down to who's in control.
You, the founder, know where the guardrails should be. You may be comfortable operating in the safe zone 80-90% of the time, but a lender will typically require you to be more conservative.
It’s also worth pointing out that some financial covenants can be a pain to calculate and report correctly. Get ready to put in extra overtime here.
The lending agreement itself will typically provide specific formulas for calculating the required metrics and any limits imposed by each covenant, but there is no rule that requires these formulas to conform to generally accepted accounting principles (GAAP).
Debt covenants, while they may seem reasonable and harmless at first, may end up being more restrictive than they look. So, always scrutinize the covenants in a loan agreement before signing and consider talking to experienced entrepreneurs in your peer network too.
Loans without debt covenants
There are some lenders that will approach debt covenants with care. That is to say, they try to be as minimally restrictive as possible with what their covenants require. And they will be apt to work with companies that breach a covenant to see how they can repair the damage amicably.
When used responsibly, debt covenants should lay out clear, minimally restrictive boundaries that establish a sense of security for both lenders and borrowers.
At Lighter Capital, we seek to enable entrepreneurs to exercise their business sense with the least interference from us. In pursuit of that goal, we don't use debt covenants in our startup business loans; instead, we rely on general operating requirements in the loan contract to ensure borrowers keep the business running.
In other words, if you meet our qualifications, we align the loan to your business, give your startup the cash and let you take it from there.
Unlike traditional banks and lenders, we use data that informs our underwriting process — before we fund a startup, we have a very good understanding of where they are in their life cycle and where we can expect their business to go. We also gather ongoing monthly data to monitor company performance. We’re data-driven and can assess a SaaS startup’s health quite accurately.
Additionally, since we’ve worked with more than 500 tech companies providing more than 1,000 rounds of financing, we have the benefit of more than decade of experience and a strong sense for technology businesses that are likely to succeed.
Learn more about debt financing for startups
Learn the ins and outs of startup debt financing so you can avoid tricky terms and conditions that might hold your business back. See how to compare different types of startup loans, then work through specific financing examples to understand the real costs with this comprehensive guide.
