Whenever most people hear the word “Covenant” they usually immediately think of the movie Raiders of the Lost Ark, where archaeologist Indiana Jones is tasked with finding the religious artifact the Ark of the Covenant before the Nazis do. While the Ark of the Covenant contains the original tablets of the Ten Commandments which, according to the movie, were endowed with great power, the covenants that we are referring to, debt covenants, will not disintegrate all who look upon them, but they have been known to take down an unsuspecting business from time to time. Business owners should be aware of any covenants that exist within their debt agreements and how best to navigate them to ensure they are protected from their potentially harmful impact.
Debt covenants refer to specific conditions that the borrower is required to fulfill or restrictions on the activities of the business, with the design to best protect the interests of the lender. The covenants are a condition of borrowing and violations of these covenants can result in the debt becoming immediately callable (due) or the loan becoming in default, thereby increasing the interest rate or triggering other remedies. The covenants will be first broadly covered in any term sheet and then further specified in the loan contract, including the precise definition of how to calculate any covenants in order to avoid doubt or manipulation. Many of these covenants can also be a point of negotiation during the lending process; borrowers should not be afraid to negotiate with lenders on covenants that they find too restrictive or otherwise burdensome.
The exact nature and type of debt covenants will be driven by the size, maturity, and complexity of the borrowing. Smaller lines of credit or mortgages on commercial real estate will have many different terms than term loans or other leveraged finance transactions. Some of the most common covenants include:
The lender will almost always want to see some annual financial reporting, the type of which is very dependent on the loan itself. Smaller, less complex loans may only request copies of annual tax returns, whereas larger loans will require some form of formal financial statements with a report from an accounting firm, such as an audit or review.
Limitations on additional debt
Lenders can be very wary of borrowers taking on additional debt that may be more senior to their debt profile, or otherwise endanger their investment, and as such, will limit the amount of additional debt that the business can incur.
Debt Service Coverage Ratio
One of the key metrics used in both borrowing decisions and in future covenants refers to the “debt service coverage ratio” or “coverage ratio”. This ratio is calculated by dividing the free cash flow of the business (typically Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) less taxes & owners’ distributions) by the total cost of debt service (interest and principal) for the year. Just like an interest rate, the ratio lenders want to see will vary on the riskiness of the investment and industry.
Other common covenants include Leverage Ratio (Free Cash Flow to Total Debt), restrictions on the use of proceeds, restrictions on owner distributions, and clean up provisions (the line of credit must have a $0 balance for a certain number of days).
Borrowers should review all lending transactions with their legal and financial advisors, so they can understand the exact nature of the covenants. Some best practices for companies that currently have or are contemplating a borrowing transaction include:
Any covenants that are listed in a transaction should be tested against prior (and if possible current) period results to understand if the business would be in compliance for at least the 2 years prior to any borrowing. The testing should also be done on any future projections prepared to ensure that businesses have adequate coverage in the future.
Understanding the lending environment
While each industry and company will have a different debt service coverage ratio, business should have a general understanding of what others in their industry and market size have for covenants. Most lenders will want to see a debt service coverage ratio of at least 1.25-1, and some may even go as high as 3-1, depending on the riskiness of the loan and underlying business.
Even if not required by the loan covenants, borrowers should at least undergo quarterly testing of any major debt covenants to ensure they are in compliance. Catching these mistakes prior to any formal testing period will assist the company in avoiding violation of any covenants as it will give the company time to make adjustments. Borrowers should be especially concerned at year end since these will be the most common testing periods and often when businesses will undergo certain strategies to reduce taxable income; while these strategies may create benefits for tax purposes, they could leave a borrower in violation and therefore trigger adverse results. If you maintain your books throughout the year under a different method of accounting (cash vs. accrual), be sure to adjust your records appropriately when calculating your covenants to ensure compliance.
For many businesses, borrowing, and thereby increasing their leverage, can be that last piece of the puzzle to put their growth machine into overdrive. Using leverage to fuel growth can be like going into a cave in search of a rare idol – caution should be taken at every step, making certain to avoid potential booby traps for the unwary; otherwise one may find themselves crushed by a rolling boulder or unexpected covenant. By understanding the covenants in any debt agreements and best practices for navigating these covenants, a business owner will ensure that they will be dispatched with little more than a shrug (and a bullet for those of you who know the movie).