In startup finance, a covenant is a standard part of loan terms set by the lender to help ensure the borrowed money is paid back in full and on time. Founders looking to borrow funds should carefully consider any covenants in term sheets from financial institutions or private debt providers to ensure they fully understand how they could affect their business.
What is a covenant?
A covenant can be broadly defined as a binding agreement between two parties to perform, or refrain from, a specific action. For businesses seeking to borrow funds, covenants are a standard part of loan terms that describe specific conditions or actions they must comply with. For financial institutions and private lenders, covenants are in place to help mitigate their risk and ensure they are paid back fully.
While startups often turn to venture capital for funds, they may also require loans to help with operating costs or to extend their runway. The covenants included in loans provided by financial institutions and private lenders are relatively standard, but there can be differences based on the stage of the business borrowing the funds, as well as type of debt.
A startup that’s cash-burning and not yet profitable poses higher risk to a lender than an established business that’s been profitable for many years. As a result, loan covenants for an early stage business will often differ from covenants for an established company.
Types of covenants in loan terms
When borrowing from financial institutions and debt providers, startups will come across loan terms that may include negative covenants, positive covenants, and financial covenants (sometimes called loan covenants or debt covenants.) As the words imply, negative covenants define the borrower’s restrictions—what they must not do; whereas positive covenants define what a borrower is required to do. A loan agreement would include positive and negative financial and non-financial covenants.
What are financial covenants?
Financial covenants are loan conditions that relate directly to a borrower’s financial performance and are commonly included in the loan terms of an operating line of credit.
“Financial covenants are a health measure. They provide a means to catch and solve problems early, thereby also managing the bank’s exposure.”
“Financial covenants are a health measure,” says Alida Kanani, Vice-President, Credit Advisory, RBCx. “They provide a means to catch and solve problems early, thereby also managing the bank’s exposure.” To ensure your company remains in compliance with financial covenants, you typically must submit financial statements and other documentation on a monthly, quarterly, or annual basis.
If the lender tests covenants on a monthly basis, for example, the borrowing company would likely be expected to prepare and submit a compliance certificate showing the calculation of the covenant, as well as supporting financials. The bank’s compliance team would also perform an audit on the company’s calculations.
Financial covenants for startups
The differences between a startup and an established company are reflected in financial covenants. Conventional methods to measure the financial performance of an established company, such as tracking revenue, earnings, or operating cash flow don’t typically work for startups which are cash-burning and may still be working to achieve product-market fit and build a customer base.
Liquidity covenants for startups
Liquidity covenants are a type of financial covenant often used for startup companies. “Liquidity covenants are pretty flexible,” says Alida. “The lender wants to see a predetermined number of months of cash on the balance sheet.” If the company drops below that amount, says Alida, “the bank or lender can increase the frequency of conversations around cash being tight and the plan to address it, such as reducing burn rate or raising more money.”
A liquidity to cash burn covenant is a type of liquidity covenant that tracks the cash runway of a pre-profit company. The cash burn rate estimates the number of months a startup can sustain its operations until it runs out of funds, and a liquidity to cash burn covenant will usually require at least three to six months of cash runway. If the borrower falls below that, the covenant is considered breached and actions would be taken by the lender to address it.
“We see the balance sheet and usually get monthly financial statements for cash-burning companies because we want to monitor how the company is performing on a month-to-month basis,” says Alida. “We understand that as the market dynamics change, the economy changes, and so does your ability to meet your projections, especially with a startup, as they’re more subject to volatility.”
Growth covenants for startups
Another type of covenant used for startups is a growth covenant. This type of covenant is included in the debt terms for pre-profit companies that have a high enterprise value. An example of a growth covenant is the performance to plan covenant in which a company must meet a percentage of its forecasted fiscal year plan (i.e. 85% of its FY plan.)
“This would be used for pre-profit companies with high enterprise values as it ensures the company is on track with the milestones that help with future equity raises,” says Alida.
Once a company does become profitable and plans to remain that way, more appropriate financial covenants are used, such as a minimum debt service coverage ratio (DSCR), which is calculated by dividing a company’s net operating income by its debt service (the sum of all current debts, including principal and interest.)
Financial covenants and venture debt
Cash burning startups that are backed by venture capital (VC) may turn to venture debt for additional funding. Companies that acquire venture debt are expected to draw on it only when their runway starts to fall short to achieve key milestones. Unlike an operating line of credit, venture debt is underwritten to the VC fund, rather than recurring revenue or assets; as a result, financial covenants are typically not included in venture debt.
“Venture debt is primarily underwritten to the quality and reputation of the investors while an operating line of credit is underwritten to the fundamentals of the business.”
“Venture debt is primarily underwritten to the quality and reputation of the investors while an operating line of credit is underwritten to the fundamentals of the business,” says Alida. However, venture debt does come with warrants to mitigate the risk to the lender, typically making it more expensive than an operating line of credit.
What are non-financial covenants?
Non-financial covenants are used in operating lines of credit and venture debt, and are generally standard and straight forward across all the major lenders. However, there may be some variation between lenders depending on their risk tolerance. Private debt providers that charge a higher interest rate are likely more risk tolerant than large banks that tend to be more conservative and risk averse. As a result, borrowers of private lenders may have less restrictive covenants. Companies that have multiple loans with various lenders should, therefore, thoroughly review and understand each loan’s terms to avoid “tripping” (or breaching) a covenant unintentionally.
Non-financial covenants may include:
- Limitations on additional debt, liens, guarantees, and investments and loans to others.
- Restrictions on mergers and acquisitions, capital expenditures, and shareholder and other distributions, as well as a material adverse change (MAC) clause (which enables the lender to take action to protect itself when serious concerns surface with the borrower).
Examples of non-financial covenants include:
- The borrower cannot make more than a certain dollar amount of capital expenditures in a given year without the bank’s consent.
- The borrower cannot have more than a maximum per cent ownership change into the company without notifying the bank.
Although covenants can come across as restrictive to startup companies, this is not the intent, explains Alida. “The intent of covenants is not to handcuff the business. It’s intended to get the lender and the borrower back to the table to discuss the rationale behind the decisions.”
It’s up to each business to fully review and understand the covenants included in a loan’s terms to ensure it can meet the required obligations. Not doing so could put the borrower at risk, as the lender is within its rights to demand repayment if a covenant is breached.
What happens if a company breaches a debt covenant?
If a company breaks a covenant, the financial institution has the right to demand repayment of the entire loan amount; but this is unlikely. “We would have a conversation about it and work with the company to figure out ways to cure it,” says Alida. Banks often offer a cure period of 30 to 60 days in which the company can ‘right the ship’ with a plan of action to get back on side.
“Covenants act as guardrails,” says Alida. “Like an early warning signal to trigger any red flags that may arise in the company that brings the borrower and bank or lender to the table to discuss a plan of action.”
What startups should know about covenants
When a startup takes on new debt, it should thoroughly review and understand the covenants in the loan terms as they can impact your startup in several ways.
- Reporting requirements: If a covenant requires a compliance certificate and financial reports, you may want to stress test the covenant beforehand to ensure your startup can comply. When comparing offers, consider how well the lender understands your business so that the covenant can be structured appropriately. “That way, if things don’t go as planned, there’s enough room (built into the agreement) that it won’t trip the company,” says Alida.
- Covenants are often non-negotiable: In general, covenants are necessary, simple, and standardized across all major lenders and non-negotiable. But carve-outs may be possible. For example, the restriction on using an operating line of credit to make an acquisition is standard across all financial institutions. “However, you may be able to negotiate creating a carve-out that allows acquisitions up to ‘X’ amount,” says Alida. Similar restrictions (and potential carve-outs) exist on making distributions or making a capital investment. “What banks are trying to do, especially for cash burning companies, is to keep the cash inside the business other than what’s necessary to be spent on growth,” she says. “We (the financial institution) want to have discretion over where the cash is going.”
- Consistency among multiple loans: If a company has multiple debt providers, it’s important to ensure the covenants are aligned to prevent tripping an agreement unintentionally. A big bank, which is more risk averse than a private debt provider, will have more conservative covenants than the latter. If your company has loans from multiple lenders and you’re not fully aware of the differences, the chances of breaching a covenant—while still adhering to another—is possible.
Loans provided by banks and lenders can offer startups breathing room and help drive growth. As covenants are a necessary part of loan terms, it’s in the borrower’s best interest to understand their potential impact and the company’s ability to comply over the long term. While covenants can be restrictive, they can also motivate a company to be more fiscally responsible and intentional on how it spends and operates.
“There is a misconception that a covenant can restrict a company’s ability to raise additional capital,” says Alida. “But that is not the bank’s intention for setting up a covenant. They are not preventing the upside, they are preventing the downside.”
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