Have you ever made a deal with caveats and conditions?
Covenants are put in place by lenders in order to protect themselves. These stipulations give the borrower clear expectations for the loan contract and enable both parties to maintain the loan terms.
But should you consider a loan with a covenant?
It might affect your business more than you expect.
What is a Debt Covenant?
Debt covenants, also known as financial covenants, are restrictions that lenders can include within a loan deal. They tie the borrower into an agreement in order to approve the loan. A financial covenant can be affirmative (you must do…) or negative (you must not do…).
A debt covenant will either tie terms into company performance (like certain financial ratios) or operations. For example, the lender says the borrower must grow tangible net worth by 2% per year over the course of the loan term.
Debt covenants are drawn into the contract and act as insurance. They protect the interest of the lender while ensuring borrowers can access capital and funding.
Negative Covenants
Negative covenants are the restrictive actions placed on the borrower. Lenders can build a wall around the actions taken by the borrower in order to prevent company and asset depreciation. In this way, the business is controlled and the lender is more likely to be repaid.
Negative covenants are actions that the borrowing company must not undertake. Typically, these agreements tie the debt into specific operational actions and are in place in order to prevent loan default.
For example, the lender could set a debt restriction to ensure the total debt is at a limit of no more than $5 million. This would ensure that the borrower meets its coverage ratio, which is the ability to meet debt obligations alongside other financial commitments.
Affirmative Covenants
These are positive actions that the borrower will adhere to. Affirmative covenants place emphasis on the actions that the borrower must take in order not to violate the conditions of the loan agreement.
The borrower must maintain operational affirmative covenants in order to meet the demands of the lender. They are typically operational rather than financial in order to run a healthy business and return the principle amount plus interest.
For example, the agreement’s affirmative covenants could state that the borrower should provide financial statements each quarter to the lender. This helps the lending party in knowing that the business maintains a credible book of accounts and is legitimate in its cash usage.
Examples of Debt Covenants
A common debt covenant is related to the company’s EBITDA margin. This stands for earnings before interest, taxes, depreciation, and amortization. It offers a snapshot into the business’ profitability without including the impact of factors such as assets.
Find your EBITDA margin with the following calculation:
Ebitda margin = EBITDA / Total Revenue
For example, the loan agreement could limit the EBITDA margin to a minimum of 10%, or specify a debt to EBITDA ratio. This would present a lower risk to the lender and is more useful than some other financial ratios.
Other common debt covenants include:
- the borrower opening insurance policies as extra security in case of loan default
- the borrower must maintain a tangible net worth of at least $x million
- the borrower should have a certain debt to equity ratio
- the borrower cannot pay cash dividends to shareholders for the duration of the loan
- the borrower cannot undertake certain agreements with outside parties
Why are Debt Covenants Important?
Debt covenants are used in order to secure loans that might otherwise not be approved. Tying these conditions to the loan agreement creates security for the lender. Without a debt covenant, the borrower is unlikely to be approved and may have to find a high-interest alternative.
The violation of debt or financial covenants can lead to a default on the loan. As it is a contract breach, the lender will decide what happens next. The borrower may be expected to pay the principle amount along with interest owed in cash, immediately. Or, the two parties may sit down to work out alternative financing.
Benefits of debt covenants
Debt covenants can be positive for both the lender and borrower. On the lending side, covenants help secure capital investment. They give the lenders control over how the company operates and give the best chance possible of guaranteeing payments back to the lending company.
For borrowers, the benefit is access to a loan that might otherwise not be approved. These companies prefer to take out a low-interest loan with covenants to aid sustainable growth rather than a high-interest loan that risks crippling them.
Disadvantages of debt covenants
The disadvantages of debt covenants may outweigh the positives for some borrowers. Performance-based debt covenants place restrictions on the borrower that could be difficult to maintain. Moreover, lenders could expect unrealistic performance, which typically leads to a breach in the loan terms.
Of course, this places the rest of the company’s assets at risk. The covenant might not be the best or most efficient path towards growth, but the borrowing party can’t escape its restrictive nature.
Debt covenants are similar to equity-based financing in that control is given to an outside party. It may mean that senior decision-makers are leveraged into awkward positions as control is relinquished to the lender.
Alternatives to Covenant Debt
The interference caused by covenants forces borrowers into conditions that may not be the best for business. But you know your company and how best to run it. Therefore, an alternative method of funding might be better suited to your situation.
R&D Finance does not include debt covenants within a lending agreement. In fact, the eligibility for the R&D tax credit scheme means that even companies outside of the parameters can claim R&D tax credits. This is a reliable and sustainable source of operating cash.
Even better, Fundsquire can advance 80% of the future tax credit up to 9 months before your business is eligible to claim from AusIndustry. It creates more working capital in order to speed up the growth of the company.
While sometimes debt covenants can be useful for highlighting clear boundaries, they can also be restrictive for creativity. But R&D funding doesn’t require the release of equity or place conditions on the loan. It instead releases the appropriate cash flow for sustainable growth.