What are covenants?
Covenants are agreements made between the lender and the borrower to achieve specific performance goals. They can come in the form of profit, asset, and growth covenants.
Profit covenants deal with maintaining a certain amount of profit or staying below a certain burn rate. Generally this type of covenant is seen with banks rather than alternative financiers, because it’s not focused so much on scaling your business, so it can seem restrictive. But for banks, it’s an easy way to track how much cash is safeguarded and eventually paid back to the bank.
Asset covenants require the company to maintain a certain level of assets. This could be with just one type of asset or a combination of assets, such as cash, accounts receivables, inventory, etc. Asset covenants can be beneficial for lenders in the event that something goes wrong, they can sell assets as a form of repayment.
Growth covenants deal with maintaining a certain level of revenue or revenue growth. This is more prevalent with businesses that aren’t profitable or don’t have assets, like startups. This promise of growth indicates value for the lender, so if something does go wrong, the business can be sold to pay the lender back.
Affirmative and Negative Covenants
Along with profit, asset, and growth covenants, they can also be separated into two categories: affirmative and negative covenants. Affirmative covenants are reminders of what the borrower should accomplish, otherwise they are at the risk of defaulting. Negative covenants are restrictions for the borrower on certain decisions for the lender’s sake.
What is the purpose of covenants?
Covenants allow lenders to easily track whether the borrower is close to achieving the targets set by the lender. The closer the borrower is to attaining the target, the less likely they will default. These targets can be in the form of credit limits, tax obligations, and even investing rights for the borrower.
What happens if the borrower breaks a covenant?
In this case, the lender will want to rectify the situation as soon as possible. This usually involves a series of renegotiations, but this isn’t always easy to do. Some negotiations can be as extreme as insolvency or liquidation. Often, it’s much lenient like offering extensions, waivers, debt buybacks, amendments, and much more.