What are Debt Covenants? — How They Work

debt covenants

Debt covenants are in every loan agreement established by a lender and borrower.

This refers to the lender’s terms and conditions that the borrower agrees to follow until you repay the loan.

This sort of agreement is in contracts, and it requires one or more parties to take a certain action, or abstain from it.

They are commitments that cannot be broken without the other contracting party getting all the damages, remedies, or termination of the agreement.

Anytime you sign a contract, you are probably well aware of the fact that debt covenants are generally a part of the deal.

Borrowers’ behavior is restricted by debt covenants, which lenders (creditors, debt holders, investors) impose on loan agreements to protect themselves (the debtor).

“Agree” and “promise” are common terms used in contracts. It is customary for companies to make promises as part of loan agreements.

“You agree to be profitable,” as in you have to have a positive net income, or “you commit to keeping $100,000 in cash on hand at all times,” are examples of debt covenants.

Anytime you sign a contract, you are probably well aware of the fact that covenants are generally a part of the deal.

What Is A Debt Covenant?

Debt Covenant

In financial contracts (such as loans and bonds), the borrower can’t take part in a certain activity, which is referred to as debt covenants, financial covenants, banking covenants, or loan covenants.

Most lenders employ debt covenants as a strategy to ensure that a borrower’s business runs smoothly.

Moreover, it is to make the loan payment most probable. Essentially, it is a technique for lenders to micromanage borrowers to reduce risk.

Types Of Covenants:

Covenants

Covenants can be beneficial or bad. Financial covenants are terms in loan agreements that deal with a company’s financial performance, whether it be favorable or bad.

To maintain good standing with the lender, the borrower must abide by positive debt covenants (PDCs).

The borrower has to maintain a minimum amount of working capital or financial ratios within specific limits, for example.

Defined by the lender, negative debt covenants specify borrower behaviors that are prohibited by their agreement with them.

It might be stipulated that the borrower cannot use company cash to purchase another business.

Covenants that indicate what the borrower must do are called positive debt covenants.

As An Example,

  • In some financial ratios, you must reach a particular level in order to be considered successful.
  • Facilities and factories should be kept in good operating order at all times.
  • Maintain capital assets regularly.
  • Strictly adhere to GAAP when it comes to accounting practices.

Negative debt covenants state what the borrower is prohibited from doing.

As An Example,

  • Over a particular amount or threshold, you have to pay cash dividends in cash.
  • Sold some of your assets.
  • Continue to take on new debt.
  • Issuance of debt that is senior to the existing debt.
  • Consider entering into a variety of contracts or leases.
  • Assist in certain M&A transactions.

Restrictive Covenants:

There are two types of debt covenants: Positive and Negative Covenants “You shall” is the positive covenant; “you shall not” is the negative covenant.

Because they restrict your actions, negative agreements are also restrictive agreements.

If they are restricted in nature, debt covenants are significantly more hazardous for debtors.

Inadvertently violating too restrictive covenants can be easy, and even those that are easy to satisfy might artificially impede a business’s capacity to take innovative or courageous action.

Also Read: 5 Moving Loans for Relocation Expenses

What Is The Purpose Of Debt Covenants?

Purpose Of Debt Covenants

For the borrower to remain in good standing with the lender, a debt covenant specifies the criteria that you must follow.

Moreover, it also specifies the things that you shouldn’t do.

As far as business operations go, covenants can range from the fundamentals, such as sustaining the business and operating it legally, to more particular and sophisticated obligations.

In many cases, covenants are financial in nature, such as the requirement to maintain a particular growth rate or a minimum amount of runway.

Unexpected turnover, spending in the wrong places, or trouble collecting payments from consumers might cause a firm temporarily to break a covenant with its lender.

If they even slightly violate a financial agreement, they are in trouble. When they reach that stage, they will typically have seven to thirty days to remedy the issue.

Next, the lender must decide how they would manage the issue to reclaim their fees and recover the principal owed to it.

Violations of a debt covenant might result in various fines. When everything else fails, the lender and borrower will strive to comprehend one other’s perspectives to come up with a solution to the issue at hand.

Lenders that are not willing to work with you may declare default on the loan, impose penalties, or call the loan — that is, demand immediate payment.

Several Reasons Why A Company Would Wish To Avoid Debt Covenants:

Debt Covenants

A borrower may accidentally violate a covenant if it is excessively restrictive.

Think carefully about what it would take to break one of the covenants in the contract you are about to sign before you agree to it.

Borrowers should be careful if violating a debt covenant appears to be within the realm of possibility.

A single slip-up might result in the owner losing control of their firm until they can pay off the entire loan.

Restrictive covenants can constrain founders even if they are not at any risk of breaking them.

They force them to operate in ways that may not be ideal for their business’s success.

It boils down to control, just like diluting. This is because you know where the guardrails are, as the founder. However, a lender may need you to be more conservative than that.

The borrower is additionally burdened by the fact that some financial covenants are difficult to calculate and disclose accurately.

There is no need that the formulae used to calculate the relevant measures.

Moreover, any restrictions imposed by each covenant adhere to widely accepted accounting standards (GAAP).

This is why debt agreements, at first sight, can be deceiving. They could really be more restrictive than they seem.

Does Lighter Capital Impose Debt Covenants On Its Investors?

Investors

When it comes to borrowers at Lighter Capital, they want them to use their business sense with the least amount of intervention.

Most of our loans do not include debt covenants, therefore we rely on basic operational criteria in the loan contract to guarantee that borrowers maintain their businesses functioning smoothly to achieve this aim.

The company decides loan decisions mostly on data — before they finance companies.

They have a very strong knowledge of where we are in our life cycles and what they can expect us to do in the future.

They also collect data regularly to keep tabs on the company’s progress.

Their data-driven approach allows them to analyze the health of a SaaS firm with great accuracy.

With more than 350 software firms that they have financed in over 600 rounds of funding.

Moreover, they have gained valuable expertise and know which businesses are likely to thrive in the SaaS market.

Their contracts only contain debt covenants when they decide to lend money to a firm that would not ordinarily be approved. 

In the case of a firm with erratic cash flow, they could require a minimum cash covenant to ensure that the borrower pays each month.

When it comes to debt covenants, they take a cautious approach as conscientious lenders. That is to say, they aim to make the covenants as flexible as feasible.

Benefits Of Debt Covenants:

Debt

You will see that both parties benefit from debt covenants in the instances below. Lenders may be hesitant to provide money to a firm if there are no such agreements in place.

Consider the following two scenarios.

Scenario 1:

A lender lends a firm $1 million. The lender lends at a 7 percent annual interest rate based on the company’s risk profile.

It is possible for the firm to instantly borrow $10 million from another lender if there are no covenants (Lender B).

In this case, Lender A would impose a debt limit on the borrower’s account. A 7 percent interest rate was computed based on the company’s risk profile.

It will be riskier to lend to the firm if it then borrows more money from other lenders.

Consequently, there is a greater chance that the firm may fail on its loan repayment to Lender A as a result.

Scenario 2:

Lender A lends a business $10 million!

Here, Lender A will restrict dividend payments. The company can pay out all earnings or liquidate assets and pay a dividend to all shareholders without limitation.

As a result, if the firm were to dissolve and pay out a liquidation dividend, the lender would be out of money.

Also Read: Gemini vs. Coinbase: Which Should You Choose?

Conclusion!

So, now you know everything necessary. Make sure that you make a wise decision.

Good luck!

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