Debt covenant - Confluence.VC

In its broadest meaning, a covenant is an agreement or promise between two parties. The covenant stipulates that the parties will agree to specific activities.

ย 

Finance covenants usually refer to terms in a financial contract, such as a loan agreement or bond issue, that outline the limit at which the borrower may lend more. Covenants in religion often reflect the binding relationship between humanity and a deity.

ย 

Takeaways:

  • Covenants are legal agreements between multiple parties. They establish a legally binding agreement about how each party will perform their duties.
  • Covenants can be either positive or negative.
  • Most lenders use debt covenants to place financial covenants on the borrower as part of their loan agreements.
  • Covenants are legally binding clauses that can be breached and will result in legal actions or compensation.
  • Covenants are used in many contexts. They can be found in finance, law, or religion.

ย 

ย 

Looking to level up your VC skills? We’ve got you covered.

Confluence.VC Resource Library

ย 

ย 

What are debt covenants?

To limit the actions of the borrower (the debtor), lenders (creditors, creditors, investors) enact debt covenants. In other words, positive debt covenants can be agreements between a company (or its lenders) that the company will follow specific rules. These are also known as financial covenants and banking covenants.

ย 

The loan covenant is not intended to place an undue burden on the borrower. They align the principal and agent’s interests and solve agency problems between management (borrower) and debt holders (lenders).

ย 

Understanding covenants

In business terms, covenants are financial ratios that must be maintained. These include a maximum debt-to-asset ratio and other similar ratios. Covenants can cover everything, from minimum dividend payments to maintaining working capital for critical employees.

ย 

The lender can either call the borrower back or take steps to reduce the lenderโ€™s risk if a covenant is broken. There are generally two types of primary covenants in lending agreements: affirmative covenants and negative covenants. The third type of covenant, financial covenants, is sometimes a sub-category.

ย 

Affirmative Covenants

A clause in a loan agreement that requires the borrower to take specific actions is called an affirmative or positive covenant.

ย 

Positive covenants require borrowers to have adequate insurance and to provide audited financial statements. They also must comply with all applicable laws and maintain a proper accounting book and credit rating.

ย 

In most cases, a violation of an affirmative covenant results in default. Some loan agreements may include grace periods that allow borrowers to correct the violations. Creditors can demand immediate repayment of any accrued interest and principal if the default is not rectified.

ย 

Negative Covenants

Negative covenants are designed to prevent borrowers from taking actions that could lead to a decline in their credit rating and ability to repay debt.

ย 

Negative covenants are used to prevent or restrict specific actions from occurring. Some examples of typical negative covenants are preventing a company’s shareholders from receiving dividends, limiting management fees to be paid to related parties, or restricting the amount a business can borrow.

ย 

A negative covenant can be circumvented with the explicit approval of the issuer. Imagine a company wanting to merge but being prevented by a negative covenant. The company can move forward if the other party to the covenant agrees to lift the restriction. This could also apply to the acquisition or capital investment of real estate.

ย 

Financial or Numerical Covenants

A covenant can also be linked to a particular numerical metric.

ย 

This metric, usually financial, maybe a single number used to calculate a specific value ratio. It is essential to monitor a financial covenant over time, as it will likely change suddenly.

ย 

One argument is that a financial covenant can be viewed as positive or negative. Imagine a company being required by law to maintain a certain ratio of financial assets above a set amount. This could technically be considered a positive covenant because it imposes a requirement.

ย 

Some people view both positive and negative covenants as one outcome (i.e., A company must keep GAAP records. Financial covenants are used to evaluate the operating performance of an entity to assess its overall health.

ย 

Financial loan covenants in business are often divided into maintenance and incurrence covenants. Many maintenance covenants require that operating performance be maintained. The interest coverage rate is an example to show that a company can earn enough to pay interest assessments.

ย 

When a company takes actions that hurt its financial performance, incurrence covenants are created. A company, for example, must keep its debt-to-equity ratio at or above 0.40. It must comply with the incurrence covenant if it wants to borrow more.

ย 

Implications of a debt covenant

Lender

Lenders are protected by debt restrictions that prohibit certain actions of borrowers. Debt covenants prevent borrowers from taking actions that could significantly affect the lender or increase their risk.

ย 

Borrower

Debt restrictions are beneficial for the borrower by lowering the cost of borrowing. Lenders will often impose restrictions to help compensate.

ย 

Why are debt covenants used

The lenders and the company should agree to debt covenants in the following scenarios. Lenders may not be willing to lend money to companies if they do not have such agreements.

ย 

Covenant Violations

A covenant violation, also known as a breach of covenant, is a failure to adhere to the terms of a covenant.

ย 

The contract is void if a party fails to fulfill a positive covenant or performs a task it shouldn’t, as defined by a negative covenant.

ย 

Debt Covenant Violations

A breach of the bond covenants is called a bond violation. When the covenant is included in the bond’s Indenture (the binding agreement between two or more people), it is intended to protect both parties interests.

ย 

If an issuer breaches a bond covenant, it will be considered in technical default. The standard penalty for breaking a bond covenant is to have a bond’s rating downgraded. This could make the bond less appealing to investors or increase borrowing costs.

ย 

Moody’s, the United States’ most prominent credit rating agency, rates bonds’ covenant quality from 1 to 5. Five being the best. A bond rating of five indicates that covenants have been consistently violated.

ย 

Other Violations

A party can seek damages compensation from another party if they have broken a covenant. Failure to follow association rules and covenants can result in fines or liens. Although an HOA cannot force homeowners to sell their homes, it may require liquidation or transfer of ownership.

ย 

Infractions of law covenants can result in penalties, fines, fees, and even more severe legal punishment. You are bound to pay for the space you have reserved if you park your vehicle on the street side. You could be issued a parking ticket if you don’t comply. A failed covenant can be found in any court case or proceeding.

ย 

Different religions have different rules regarding the consequences of not adhering to certain teachings. According to the Quran, Allah will not forgive anyone who does not believe in Islamic teachings. He will also guide them “to the right path.”

ย 

Bottom line

In financial agreements, such as loans and credit lines between lenders or borrowers, some clauses limit certain activities like dividends or asset sales to protect the lender’s interests and keep their risk exposure at an acceptable level.

ย 

Understanding debt covenants is key to choosing the right lender. A loan agreement should provide your company with sufficient support to meet its capital requirements and operational needs. If a covenant-lite loan does not meet your current needs, a covenant-lite loan may be more appropriate than one with many restrictive clauses.

ย 

To learn more about other terms commonly used in venture capital,ย check out our complete VC Glossary.

ย 

Want better VC emails?