Making and Keeping Covenants

Welcome back to INTRO to Finance. I'm Jason, and this is your weekly dose of financial food for thought (and action!). The US tax code has dominated the internet this week, so we thought we’d do our part and leave the subject alone.

Instead, we’re going to talk about the exciting topic of covenants. This week we’ll answer:

"What kind of covenants do alternative financiers require?"

As you might remember from previous posts, covenants are an agreement between you and the lender for the business to maintain specific performance metrics. Financiers require financial covenants to reduce risk. If the company can commit to the financial covenants, the financier is more comfortable doing the deal.

However, it can be challenging to commit to a certain amount of revenue, assets, or profit when your company is young and growing inconsistently. With limited operational history, it can be challenging to know with certainty what the future holds. 

The good news is that you shouldn't expect the same extreme requirements that you would from a more traditional lender, like a bank. Most alternative financiers have flexible covenants that a young, growing business might find reasonable.

The Three Types of Financial Covenants

Profit Covenants
The company must maintain a certain amount of profit or not exceed a certain level of burn.

Financiers like this covenant because it safeguards the cash that will ultimately go to paying back the financing they give the company. Requiring profit can sound restrictive for a scaling business. This is why alternative financiers don't use this covenant much. It’s much more prevalent from banks.

Asset Covenants
The company must maintain a certain amount of assets. The covenant could be to maintain an amount of a single asset, such as cash. Or it could be a ratio of keeping a combination of assets, like cash, inventory, and accounts receivable. 

Keeping a level of assets in the business helps financiers feel confident that the company could sell those assets to pay back the financier if something terrible happened to the business.  

Growth Covenants
The business must maintain a certain level of revenue or revenue growth to stay in good standing. 

These covenants are more prevalent in alternative financing situations because the business may not have profit or assets to make the lender completely comfortable. Instead, the lender believes that the business's growth showcases that the company or product has value. If something terrible happened, there is enough value to sell the business to pay the lender back.

How They Get Set

The process of setting the covenants is collaborative. First, the lender will want to review your projections and understand what the expectations are for the business. If you’re wondering what forecasts you should be sharing, check out the forecasting section of our post on preparing to raise debt.

The financier will make a recommendation on a covenant they’d like to see. If you’re concerned the covenant will be set to the level of what you sent in projections, don’t worry. It’s uncommon to have the covenant set at 100% of the plan that you send over. Most covenants are less than 90% of the plan that you present. 

This added cushion allows the company to make some mistakes. Lenders don’t want you to fail. The goal is to have something you feel comfortable reaching and gives the lender peace of mind. 

Unless you’re dealing with a bank or restrictive lender, this will be a conversation about finding the right answer rather than a strict list of requirements.

You don't want to go into an arrangement knowing you won't keep the commitment. Just as important, the financier won't want you to turn down the financing without a chance to find something mutually agreeable. For most lenders, finding a creative solution that works for everyone is where they find joy in the work.

When to Expect Them

Because covenants can be a challenge for financiers to work with young, growing companies, they’re not as prevalent as they used to be. The more traditional financing types, like term loans or lines of credit, may require covenants. Still, even then, it’s less common for these types of financings for deals under $500k. 

As for other non-dilutive financing types, covenants are very rarely involved. This is true for most of the financing types that we have in INTRO.

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