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Venture Debt: How Covenants Can Be Good, Bad or Ugly

October 16, 2013

In my prior post , I gave an overview of the theory behind financial covenants in venture debt deals and some basic examples of the types of covenants used by lenders.  With this post, we will take a deeper look at what happens when a covenant is violated, and the pros and cons of venture debt deals with covenants.

When a covenant violation occurs (often called “tripping” a covenant), it is technically a violation of the terms of the loan agreement.  While the actual repercussions and remedies available to the lender will vary from deal to deal, in general, lenders have several options.

First, most debt deals have a default rate term which provides the lender with the ability to increase the interest rate on the loan in the event of a default and until the default is formally addressed in some fashion.  The default rate will typically be noted in the section of the loan agreement dealing with the interest rate for the specific loan, and there will likely be a cap on the allowed amount of the increase.  A lender may or may not choose to invoke the default rate, but the trip of a covenant is the event that allows the action.

Second, within the loan documents there will be explicit terms that outline the lender’s rights and remedies in the event of a default.  The range of remedies is widespread, with the simplest being that most lenders will not allow any additional extensions of credit (i.e. advance requests for more money) as long as the company is in default.  The harshest and potentially most damaging term is the ability of the lender to declare all outstanding obligations due and payable upon the event of default.  Depending on the liquidity position of the company and/or access to additional capital, this could lead to a scenario in which the company does not have adequate capital to both repay the loan and continue operations.

As noted in Part I of the covenant post, the worst-case instance described above is very rare.  The vast majority of covenant violations are dealt with via alternative methods.  These methods can vary, but the commonality among all is that some action is a requirement – it is not acceptable or realistic for a violation to remain outstanding in perpetuity.

Depending on the severity and nature of the covenant violation, the likely action is either a waiver of the default or a restructure of the deal either through amended covenants or a new structure altogether.  A waiver is the preferred outcome for most companies as it essentially is a get-out-of-jail-free card;  it is a formal note that a violation occurred, and an equally formal acknowledgment that the lender is waiving the violation and no longer retains the rights and remedies to address the specific default.  There’s no double jeopardy with a covenant waiver.  This is a typical response when the violation is minor, due to a timing difference or there was an event that occurred after the violation that mitigated the risk and overcame the default itself (for instance, a large round of equity, which can cover up a multitude of sins in a lender’s eyes!).

When a violation is severe or there is a covenant with cumulative or dependent characteristics, it’s often unlikely that a company will be able to comply with future covenant levels after an initial default.  In this case, a full restructure of the covenants is needed.  In many ways, this process takes the same shape as the initial negotiations that led to the original covenant structure.  The lender will discuss options with the company and also touch base again with the equity sponsors to determine their level of support, especially if the primary source of repayment is additional equity capital.  The new covenant structure may simply involve new levels within the same structure or there may be a different, or additional, covenant.  Further, a covenant restructure is often used by a lender as an opportunity to amend the interest rate, amortization terms, charge additional fees, and/or take on additional warrants.  The perception is often that a covenant trip is a signal of increased risk and, thus, the lender looks to match the change in risk profile with credit enhancements and/or a higher return.

In the event of a covenant trip, it’s important to keep in mind the implicit contract between venture debt providers and VCs, which I previously described .  For lenders with large numbers of customers, the implicit contract and reputational risk of being seen as too heavy-handed can play a large part in how decisions are made.  When considering venture debt providers, it makes considerable sense for entrepreneurial CEOs to ask their equity sponsors how the potential lenders have responded to covenant trips in the past, and what type of experience they have in working out deals that don’t necessarily go as planned.  Leveraging the historical relationship between venture debt provider and VC will help a company to not only select the best fit up front, but also assist in the negotiation of structure changes, if needed, in the future.

Of course, not all venture debt deals contain covenants and it’s worth discussing the pros and cons of having a covenant in a deal.  Many venture debt funds will provide structures billed as “no-covenant” loans, which functionally act as “cheap equity” for a company to use as it pleases.  While cheap relative to the cost of equity capital, the tradeoff with such no-covenant venture debt is often a higher overall cost than that offered by venture debt that contains covenants.

Regardless of whether or not there are covenants in a venture debt deal, virtually all transactions occurring today contain a Material Adverse Change clause.  The so-called “MAC” is a somewhat arbitrary catch-all term that allows a lender to call a default upon the occurrence of events that would represent a material change in the operations or financial condition of the company or in its ability to repay the debt obligation.  The obvious conundrum with a MAC is that it’s necessarily broad to capture a variety of potential circumstances and the definition of material change can mean different things to the various parties sitting around the table.  It can also mean different things for different types or stages of companies – an early stage company may be at 10% of plan and still able to raise a significant follow on round of equity, while a more mature company may be at 75% of plan and have no plan for how to continue as a going concern.

Combining the opaque nature of the MAC with the inherent complications of implicit relationships and contracts between parties can lead to very uncomfortable and messy situations when a lender feels it has to resort to calling the MAC.  Ironically, it is typically these situations that blow up in the face of all involved and give venture debt as a whole a bad name with some in the industry.

With this knowledge as a backdrop, one can understand the paradoxical nature of covenants in venture debt deals.  While at first glance covenants seem to be the fuse which, when lit, can blow up a company, covenants can functionally serve the exact opposite purpose.  By providing an explicit outline of expectations for all parties, covenants create definition in the deal that allows everyone involved to react rationally and transparently, even in suboptimal scenarios.  There is certainly considerable freedom and value in doing a debt deal with no covenants – and given the option of two deals with identical structure (pricing, term, etc.) one would likely choose the deal without a covenant over another with one.  Yet, I hope this two-part overview of covenants in venture debt deals helps to demystify the terms and provide some insight into how the presence of covenants in your debt deal may not signal the end of the world as you know it.

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