In the startup world, covenants are a standard part of a venture debt term sheet and we tend to think of them as the “rules of engagement” when it comes to taking on things like venture debt and leases. They are often a fundamental part of a startup’s journey, so they’re an important thing to understand.
Abiding by the Terms of the Covenants
When your startup takes on some form of loan, and especially when you’re borrowing money from a bank or a financial institution, there are going to be some covenants that establish rules that you need to follow. You need to abide by the covenants for a number of reasons:
- You must abide by the covenants in order for the loan to be available to you in the first place.
- You have to abide by the covenants to ensure your startup doesn’t go into default.
In the majority of circumstances, if you violate the covenants of your loan, you will go into default. When you go into default there are often a lot of remedies to deal with – these being financial actions that the bank or lender can pursue if you don’t abide by a covenant.
Remedies and being in default are not fun if you are the borrower. The lender may even be able to force the startup into bankruptcy or take over control of the company. So you want to avoid breaching the covenants. You should negotiate any covenants strongly before you actually sign the deal and especially before you take the money. It’s a good idea to consult a financial professional or attorney before you sign the contract. Ultimately, you want to make sure you’re not going to violate any covenants.
Examples of Covenants
Covenants in the term sheet can cover a number of different things, such as:
- A minimum figure that your negative cash flow can’t go below
- A minimum figure for the amount of cash that must be in your account at all times
- A certain number that your net assets must total
There are also administrative covenants that you may have to follow. Examples could include:
- The annual submission of your business financials
- A compulsory annual audit
Pros And Cons Of Loan Covenants
While loan covenants can lead to more favorable loan terms, they also require careful management and can limit your startup’s operational flexibility. There are advantages and disadvantages to loan covenants for borrowers.
Pros:
- Potential for lower interest rates. Lenders may offer lower interest rates if the borrower agrees to certain covenants, since these reduce the lender’s risk.
- Financial management discipline. Covenants can impose financial discipline on the startup, encouraging careful management of finances and adherence to sound business practices.
- Increased borrowing capacity. By agreeing to covenants, borrowers might gain access to larger loans or more favorable terms, as the covenants reduce the lender’s risk perception.
- Signal of creditworthiness. A startup’s willingness to agree to covenants can signal to the lender (and other stakeholders) that the startup is confident in their financial stability and management.
- Early warning system. Some covenants are designed to act as early warning systems. For instance, financial covenants like debt-to-equity ratios can highlight potential financial problems before they become critical.
Cons:
- Operational restrictions. Covenants may limit the startup’s operational flexibility by imposing restrictions on activities such as taking on additional debt or making significant investments.
- Increased administrative burden. Startups may need to monitor and report compliance with covenants regularly, which can increase administrative costs and time.
- Risk of default. Non-compliance with covenants, even unintentionally, can trigger a default on the loan, leading to penalties, higher interest rates, or even demand for immediate repayment.
- Pressure on management. Covenants may add pressure on a startup’s management to meet specific financial metrics, which could lead to short-term decision-making rather than focusing on long-term growth.
- Potential for renegotiation costs. If the borrower cannot comply with a venture debt covenant, they may need to restructure the loan terms with the lender, which can be costly and time-consuming. Lenders might also demand additional compensation or stricter terms during renegotiation.
- Impact on strategic decisions. Covenants can limit a startup’s ability to pursue strategic opportunities, such as mergers, acquisitions, or capital expenditures, without prior approval from the lender.
Be Smart About the Covenants You Agree To
Ultimately, covenants will almost definitely be there in a term sheet. They’re the rules of the game and the financial institutions that are lending you money rely on them to hold you responsible for the money you borrowed, and to make sure you face repercussions if the company starts having trouble.
The key thing with covenants is make sure you can live within them when you’re negotiating the deal. There is nothing worse than accessing debt funding, tripping covenants, and having to come back to the table with a lender.
By that time you will have basically lost all your leverage, given you’re likely to be in a weak financial position. This could lead to some pretty bad outcomes. The lender could make you sell the company, or they could foreclose and sell the company themselves.
So be very careful. Think about these points and be smart about the covenants you sign up for.
If you have any other questions on covenants, valuations, valuations, startup accounting, or taxes, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!
