The hidden upside of debt covenants

Debt covenants can be scary. If you trip a covenant such as minimum net revenue, minimum liquidity, or minimum EBITDA, all of a sudden you’re in default.  Your lender: i) will look to you to remedy the situation immediately (perhaps by raising more equity which means dilution); ii) may increasing the pricing of the loan in the form of a higher interest rate; or iii) may seize collateral/assets as a last resort.  That said, when one of our companies receives a term sheet with covenants, in some cases we actually prefer it.  Why?

 

-Covenants force you to make honest projections.  When a lender puts covenants in place, they’re generally based on projections.  For instance, a net revenue covenant may be set at 80% of projected revenue in any given quarter.  The positive side effect is your projections now need to be honest and conservative.  Covenants make you view the business from a realistic perspective, not an upside best case which many founders are prone to do.

 

-Covenants can make your debt cheaper.  Covenants make lenders comfortable, and when a lender is comfortable, they’ve got room to ease up on things like interest rate, warrants, fees, maturity, and may even be able to increase the amount they lend.  When you see covenants, always work with the lender to properly set them but at the same time ask for a cheaper loan or better terms elsewhere.  Generally, you’ll get it so long as the lender can keep the covenants.

 

Also, remember that traditional venture lenders like SVB, Square1, Bridge, and Comerica have no interest in seizing your business.  Tripping a covenant is as scary for them as it is for you, so they’ll work with you to remedy the situation and will likely restructure the debt at least once to give you some room to breathe.  In summary, I’m not telling you that covenants are good, but certainly they’re not all bad.  

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