What is a covenant?
A covenant is a type of agreement often found in contracts, which 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.” Covenants are most common in lending agreements in which a company makes a promise in return for a loan. These promises, known as debt covenants, can be as simple as “you agree to be profitable,” as in you have to be positive net income, or as specific as “you promise to maintain a minimum of $100,000 cash on hand at all times.”
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 in order to attempt to mitigate risk — a form of “guard rails” that lenders can set up to ensure a business is staying well within a margin of error in its operations.
What are restrictive covenants?
Debt covenants can be either positive or negative. While a positive covenant is an obligation to do something (“you shall”), a negative covenant is a promise not to do something (“you shall not”). Negative covenants are referred to as restrictive covenants because they limit what actions you can take.
Debt covenants are inherently risky for borrowers, and even more so if they are restrictive covenants. 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 a way that limits a business’s ability to take creative or bold action. For these reasons we rarely require covenants at Lighter Capital, whether for our revenue-based financing, term loans, or lines of credit.
To learn more about our funding options and how they differ from traditional bank loans, we provide a detailed side by side comparison of each of our products to showcase their unique funding structures and help you determine which option is best for your company.View Product Comparison
How do debt covenants work?
A debt covenant lays out the conditions the borrower must fulfill or the actions they must avoid to maintain 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 a minimum amount of cash on hand.
If a business runs into unexpected churn, spends money in the wrong place, or is struggling to collect payments from customers, the business could temporarily breach a covenant with a lender. Even if they barely breach a financial covenant, they’ll be in violation. At that point, they’ll usually get 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.
Various penalties may result when a borrower violates a debt covenant. 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.
Why companies may want to avoid debt covenants
Debt covenants can be overly restrictive, and in that case there’s a real possibility that a borrower will breach one unintentionally. Business owners should think really hard about what it would take to breach one of the covenants in the contract they’re about to sign.
If breaching a debt covenant seems well within plausible imagination, the borrower should be wary. In a worst case scenario, an owner could make a single misstep that breaches a debt covenant and then lose control of their business unless they can pony up the full loan amount.
Even if a business is not in real danger of breaching a covenant, the conservative rules imposed by restrictive covenants can mean that founders are boxed in to operating in ways that may not be best for business growth.
Just like dilution, it comes down to control. You as the founder know where the guard rails are. You may be comfortable operating at 80-90% of the safe zone, but a lender will typically require you to be more conservative than that. It’s also worth pointing out that some financial covenants can be a pain to calculate and report correctly — it’s burdensome for the borrower.
Additionally, the lending agreement itself will typically provide specific formulas for calculating the required metrics and any limits imposed by each covenant, and there is no rule that requires these formulas to conform to generally accepted accounting principles (GAAP).
Because of this, debt covenants can be very misleading at first glance and may even end up being more restrictive than they look.
Does Lighter Capital require debt covenants?
At Lighter Capital, we seek to enable our borrowers to exercise their business sense with the least interference from us. In pursuit of that goal, we don’t use debt covenants on most of our loans; instead, we rely on general operating requirements in the loan contract to ensure borrowers keep the business running.
This is primarily because of the data we use that informs all of our decision-making regarding business loans — before we fund startups, we have a very good understanding of where they are in their life cycles and where we can expect them to go. We also gather ongoing monthly data to monitor company performance. We’re data-driven, so we can assess quite accurately a given SaaS company’s health. Additionally, as we’ve worked with more than 350 tech companies providing more than 600 rounds of financing, we have the benefit of experience; we have a good sense of which businesses are likely to succeed in the SaaS industry.
The only time we insert debt covenants into our contracts is when we decide to lend to a company we wouldn’t normally approve. As we broaden the scope of which companies we work with, we are likely to use more covenants. For example, we generally lend to subscription-based businesses, so if we decide to lend to a non-subscription-based tech business, we will be more cautious and may well include a debt covenant of some kind, such as the requirement that they grow at least 1% annualized at all times. For a business that typically experiences big swings in cash-on-hand, we might have a minimum cash covenant to make sure there’s enough to make payroll each month.
As thoughtful lenders, we approach debt covenants with care. That is to say, we try to be as minimally restrictive as possible with what our covenants require. And we are apt to work with companies that breach a covenant to see how we can repair the damage amicably.
If used responsibly, covenants can lay out clear boundaries and establish a sense of security for both lenders and borrowers. But most of Lighter Capital’s lending partners don’t require that level of oversight from us, and in those cases we leave well enough alone.
At Lighter Capital, we’re revolutionizing the business of startup finance – we don’t put restrictive debt covenants on a company for a loan. Download our free Alternative Finance Industry Report in which we explore the changing landscape of tech startup financing, analyzing why founders are turning to options like revenue-based financing to fuel growth.
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