Debt covenants can be scary. If you trip a covenant such as minimum net revenue, minimum liquidity, or minimum EBITDA, 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 increase 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 certain types of covenants, in some cases we actually prefer it. Why?
Revenue and income covenants force you to make honest projections. When a lender puts covenants in place, they’re 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 are a negotiating tool. Every term in a term sheet is part of a negotiation. Allowing a lender to have or even add covenants means you can negotiate other areas of the term sheet in exchange. For instance, if we see a revenue covenant, we may also offer an operating income covenant in exchange for better terms elsewhere. In our view, minimum revenue and minimum income are so similar, accepting both is a good deal so long as you can get what you want elsewhere.
On the flip side:
Try to get rid of balance sheet covenants. The covenants we like are income statement related covenants, for instance minimum revenue, minimum MRR, or minimum operating income. These covenants require honest projections. Covenants we hate are balance sheet related covenants such as minimum liquidity. Minimum liquidity in many cases reduces the actual amount of debt you have access to and it’s one we always require the lender to remove. It defeats the purpose of the credit facility.
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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