A labor strike in South Africa and trouble with a consignment arrangement in Tanzania put Petra Diamonds (Petra) at risk of defaulting on its loan covenants, forcing Petra to renegotiate loan terms with its lender. Because the circumstances were out of the ordinary, lenders agreed to waive Petra’s debt covenants for December 2017 and reset its debt agreements in 20181. As your company begins using debt financing, you should be aware of the covenants or promises that often come with debt funding. This article explains the different types of debt covenants, what happens if your company violates its covenants, how to negotiate with lenders, and which covenants to avoid in your negotiation process.
Debt covenants provide assurance to your lender that your company will pay back its loan on time and in full. Covenants are promises to the lender that your company will do (affirmative covenants) or not do (restrictive covenants) certain things. In addition to affirmative and restrictive covenants, a lender may also require that a company meet certain financial covenants, such as capital covenants or performance covenants. The inclusion of covenants reduces risk for the lender, and borrowers are willing to include them in loan contracts in exchange for more favorable terms (e.g., a lower interest rate or longer debt maturity).
While many different types of covenants exist, the specific covenants attached to your loan will vary based on the type of lender you use, the current circumstances of your company, and the general economic condition at the time of the loan.
Affirmative (Positive) Covenants
An affirmative or positive loan covenant is a covenant that requires the company to perform or maintain a certain activity. For example, a lender may require a company to always maintain a predetermined amount of liquid assets on hand. Other affirmative covenants may include the following:
- U.S. GAAP: A company must maintain its accounting records according to U.S. GAAP.
- Audited Financial Statements: A company must send audited financial statements to its lender on a regular basis, most often quarterly or annually.
- Business Insurance: A company must have sufficient business insurance to hedge against the possibility of defaulting on the loan.
- Taxes: A company must stay current on its tax liabilities.
- Additional Loans: A company must make any subsequent loans subordinate (or secondary) to the original lender’s loan.
Restrictive (Negative) Covenants
Negative loan covenants create boundaries around a company’s activities. For example, a lender may limit the amount of total debt a company can take on. Other examples of negative covenants include the following:
- Dividends and Distributions: A company must obtain approval from the lender before paying out dividends or distributing funds to shareholders.
- Mergers and Acquisitions: A company must obtain approval from the lender before participating in a merger or acquisition transaction.
- Change in Management: A company must obtain approval from the lender before making changes to its management team.
- Long-term Assets: A company must obtain approval from the lender before purchasing or selling long-term assets.
- Additional Liens on Collateral: A company may not add additional liens to collateral that has already been promised to the original lender in the case of a loan default.
While a financial covenant may also be considered either an affirmative or restrictive covenant, financial covenants can be understood better by separating them out into their own category. Financial covenants include both capital covenants and performance covenants.
A lender may require that a company maintain, fall below, or stay within a specified range of certain financial ratios from the balance sheet and income statement. Common terms include maintaining a certain amount of liquid assets in proportion to current debt obligations (measured by liquidity ratios) or falling below a specified proportion of debt (measured by debt-to-equity ratios or debt service coverage ratios). For example, a lender may require that a company must have a Current Ratio2 of 1.2 at any given time and a Debt-to-Capital Ratio3 that is between 0.2 and 0.5.
In addition to tracking a company’s performance using financial statements measures, a lender may create covenants based on measures used by investment firms. These measures include a company’s user growth, monthly recurring revenue, or bookings4. For example, a lender may require that a company attract an additional 200 users each month or have monthly recurring revenue of $5,000 by the end of the year.
When a company violates its loan covenants, the company is in technical default on its loan. Technical default simply means that a company has violated a term or condition that is not related to making payments on the loan. If a company has defaulted on its loan, the lender has the right to call back the loan, halt future funding, seize promised collateral, charge a penalty, or enforce legal action to recover the remaining loan balance.
A lender may or may not use these measures when default occurs, depending on the severity of the infringement. For example, the lender may be more forgiving of an accidental jump above the required debt-to-capital ratio and less forgiving of the decision to add an additional lien to the collateral promised to the lender. Regardless of the severity of the violation, the lender will likely make note of the violation for future reference.
The cost to the company of violating a debt covenant can vary significantly. However, on average, debt covenant violations lead to negative stock price reactions in publicly-traded companies, an increased likelihood of CEO and CFO turnover, and a decreased ability to access debt markets in the future.
Whether you are entering into a new loan agreement, have technically defaulted on your loan, or wish to modify existing loan conditions, lenders are generally willing to negotiate on a loan’s terms and covenants. When entering into a new loan agreement, you should be aware of your company’s needs and the lender’s concerns. Understanding your company’s needs will help you know what covenants would be highly detrimental or too restrictive. Understanding the lender’s concerns will help you see the risky areas of your business and what types of covenants the lender will want in an agreement.
If you have technically defaulted on a loan by violating loan covenants, remember that the lender has a vested interest in your company’s success because your company’s success determines if the loan will be paid back completely. Be sure to give the lender advanced notice of the violation, if possible, and explain the situation thoroughly. Your lenders may agree to waive, reset, or extend debt covenants, just as lenders did with Petra Diamonds (mentioned at the beginning of the article).
Finally, if business is going well and your relationship with the lender is positive, your lender may be willing to remove or redefine covenants by amending the existing loan agreement. For instance, a lender may agree to remove an audit requirement and change it to a review at no additional cost to your company.
Risky Loan Terms
Debt is not always the best way to obtain funding. Your company needs to analyze the tradeoff between having a lower cost of debt and the covenants that will be required in the loan. Founders should be especially wary of loans that they are required to personally guarantee or that contain a confession of judgement clause, which allows the lender, in the case of default, to file a judgement against the company and individuals who guarantee the loan without filing a lawsuit.
Debt covenants are very common in debt agreements. While debt financing is typically less costly than equity financing, the debt covenants of the loan agreement may cause the loan agreement to be unattractive. Before entering into a loan agreement, your company should be familiar with the different types of debt covenants and what they will require of your company during the loan agreement. Managers should also analyze the tradeoffs of a particular loan agreement and the covenants attached.
- Journal of Accountancy: How to Effectively Negotiate Loan Covenants
- Mueller: Develop a Strong Hand to Negotiate Loan Covenants
- Forbes: Bank Loan Covenants and Clauses Entrepreneurs Regret Most
- Withum: Understanding Bank Loan Covenants
- Entrepreneur: You Violated a Covenant. Now What?
- Exit Promise: Loan Covenants Examples
- The Balance: Why Do Banks Say No to Small Business Startup Loans
- Reuters: Petra Diamonds secures new debt agreements with lenders
- Current Assets/Current Liabilities
- Total Debt/(Total Debt + Shareholder’s Equity)
- The money that a customer commits to pay in exchange for a company’s goods or services.