Financial covenants are agreements in a loan contract between the lender and the borrower that set specific financial conditions that must be met by the borrower during the term of a loan in order to avoid default. These conditions are used to mitigate the risk for the lender by requiring the borrower to maintain a certain level of financial and business performance. In venture debt, these covenants are especially important as they provide additional layer of protection to the lender in the case of a high-risk commercial loans.
Some common financial covenants in venture debt include:
1. Minimum cash balance (Minimum Liquidity): The borrower must maintain a minimum amount of cash in its account, which serves as a cushion in case of a financial emergency.
2. Debt service coverage ratio: The borrower must maintain a certain ratio between its earnings before interest, taxes, depreciation, and amortization (EBITDA) and its debt payments. This ensures that the borrower will have enough cash to cover its future debt repayments.
3. Maximum leverage ratio: The borrower must maintain a maximum level of outstanding debt relative to its assets, which helps to ensure that it has the ability to repay its loans.
4. Performance-to-plan ratio: The borrower must meet a certain percentage of its projected targets (revenues, growth, EBITDA, or else).
Main risks for the borrowers:
1. Default: If the borrower is unable to meet the financial covenants outlined in the loan agreement, it may result in default, which could lead to legal consequences, higher interest rates (default interest) and damage to the borrower's credit.
2. Dilution of ownership: To meet some financial covenants, the borrower may need to raise additional capital.
3. Strained relationships with lenders: If the borrower consistently fails to meet the financial covenants, it may result in strained relationships with the lenders and reduce the borrower's ability to secure future financing.
Financial covenants in venture debt serve as important safeguards for the lender and at the same time help to ensure the borrower's financial health. Many lenders (but not all) apply different types of financial covenants in order to lower their credit risk. It is important for borrowers to be aware of the potential risks associated with these covenants and to be prepared to meet the required conditions in order to avoid default and maintain strong relationships with the lenders.
Prior to entering venture debt deal startups should:
1. Deeply understand the financial covenants, if any, and what they require from your company;
2. Make sure that you can meet those financial requirements. Run some stress scenarios to verify the same;
3. Negotiate easier covenants figures/ratios if you are uncertain about meeting those requirements;
4. Make sure that in default situation you still have enough time to cure the default or can pay back the outstanding loan before it becomes too messy.
5. Be frank and open about these matters with the lender while negotiating the loan terms and do not pretend to be too confident, otherwise it might become your own problem down the road.
6. Transact only with well-established and reputable lenders. This is how you can often expect more predictable and professional lender’s reaction during challenging times and more fair and balanced solutions.
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