The Venture Debt Covenants, Clauses, and Provisions to Avoid
Venture debt can be one of the most effective forms of capital to grow a startup, as it typically comes with a lengthy amortization schedule (usually 36-48 months), an interest-only period, and relatively minimal dilution (e.g. warrants). However, it can also be incredibly dangerous to cash-burning startups with dynamic business models and fluctuating cash flows (e.g. most startups). The main concern is the covenants, clauses, and provisions associated with the venture debt deal and the resulting default that can occur from breaching them. Given you’re reading this guide, we’re going to guess that you’ve already a received venture debt term sheet (or two) and are looking for the covenants, clauses, and provisions to avoid. If that's the case, great, you’ve come to the right place! Let’s dive in!
Key components of venture debt agreements
Before we delve into the dirty details of venture debt covenants or provisions, we wanted to share a quick refresher on the core aspects of venture debt agreements. As you likely know, venture debt agreements cater to the specific needs of high-growth startups and as such are structured differently than traditional bank loans. The main components include interest rates, repayment terms, principal amount, collateral, and warrants.
- Interest rates - the direct fee that is paid to the lender on the outstanding principal balance, it ranges widely based on factors such as the startup’s risk profile, the lender's terms, and prevailing market conditions.
- Repayment terms - these outline the schedule for paying back the borrowed funds, which could be structured as regular installments or as a balloon payment.
- Principal - the amount of money borrowed.
- Maturity date - the date on which principal repayment is required.
- Collateral - what company assets are being pledged to guarantee the loan.
- Warrants - the sum of options (equity) given to the lender.
For more on these, check out the startup founders’ guide to raising venture debt in 2023.
The role of collateral and warrants in venture debt
Collateral serves as a form of security for the lender in case of default. It could include assets such as inventory, accounts receivable, or intellectual property. Warrants, on the other hand, provide the lender with the option, but not the obligation to purchase equity in the startup at a predetermined price before a predetermined date.
The Three Types of Venture Debt Covenants
Venture debt covenants are clauses within the loan agreement that outline certain conditions and restrictions startups must adhere to throughout the term of the loan. These conditions are put in place to protect the lender's interests and help minimize potential default risks, ensuring that the borrower maintains strong financial health & operational efficiency. There are three broad categories of covenants: affirmative, negative, and financial.
- Affirmative covenants - require the borrower to take specific actions, such as submitting regular financial statements, maintaining insurance coverage, and complying with applicable laws and regulations. These covenants provide lenders with visibility into the borrower's financial performance and overall business operations.
- Negative covenants - impose restrictions on the borrower's actions. These limitations could include restrictions on taking on additional debt, making major changes to the ownership structure, or engaging in significant capital expenditures without the lender's consent.
- Financial covenants - focus on the borrower's financial ratios and performance metrics. Common financial covenants include maintaining a certain debt service coverage ratio (DSCR), maintaining minimum liquidity and working capital ratios, and adhering to specific levels of profitability.
The most common affirmative covenants in venture debt
As mentioned above, affirmative covenants are conditions that borrowers must fulfill to ensure they are operating within a financially stable and compliant framework. These covenants emphasize transparency and accountability, providing lenders with crucial information about the borrower's financial health and business operations.
- Accurate financial reporting - Venture debt agreements typically require startups to provide regular financial statements, including balance sheets, income statements, and cash flow statements. These reports offer lenders insights into the startup’s financial performance, aiding in risk assessment and decision-making.
- Insurance coverage - Venture debt agreements almost always include covenants that mandate borrowers to maintain specific types and levels of insurance coverage, such as general liability, property, and key persons (execs) insurance to mitigate risks associated with unexpected events.
- Compliance with applicable laws and regulations - Venture debt covenants always require borrowers to comply with all relevant laws, including those related to environmental regulations, employment practices, and industry-specific standards.
- Primary banking relationship: this requires the startup to conduct all of its primary banking business with the lender.
The most common negative covenants in venture debt
Negative covenants, sometimes referred to as restrictive covenants, outline activities that borrowers are restricted from engaging in without the lender's approval. These covenants are designed to protect the lender's interests by preventing actions that could increase the borrower's financial risk.
- Incurring additional debt - One of the common negative covenants is a restriction on taking on additional debt. This covenant prevents borrowers from overleveraging themselves and ensures that the startup’s debt load remains manageable.
- Changes in ownership structure - Venture debt agreements may include restrictions on changes in ownership structure, such as mergers, acquisitions, or changes in control.
- Capital expenditure restrictions - Negative covenants set a dollar threshold on the amount of capital a startup can spend in a single category without lender approval (e.g. investments made in assets like equipment, facilities, or technology).
- Negative pledge on IP: this covenant prevents startups from pledging their intellectual property to another party while the loan is outstanding.
The most common financial covenants in venture debt
Financial covenants are directly tied to the startup’s financial performance and ratios. Breaching these covenants can have immediate and significant consequences, affecting the lender's perception of risk and potentially triggering a default.
- Debt Service Coverage Ratio (DSCR) Requirements: The debt service coverage ratio (DSCR) compares a startup’s operating income to its debt payments. This ratio indicates the startup’s ability to meet its debt obligations. Maintaining a required DSCR is crucial, as falling below the threshold could trigger a default.
- Minimum liquidity and working capital ratios: Liquidity and working capital ratios measure a startup’s short-term financial health. These ratios ensure that the startup has enough liquid assets to cover its immediate obligations. Breaching these ratios could signal financial distress and prompt lender action.
- Maximum loan-to-value ratio: this covenant requires the startup to maintain a particular upside valuation multiple compared to the outstanding debt.
- Minimum revenue target: this covenant outlines the specific dollar amount of revenue that the startup must generate each quarter.
The most common venture debt clauses & provisions
Venture debt provisions and clauses are similar to covenants, in that they are conditions or requirements of the deal, however, they are usually more prescriptive and can cause greater harm to the startup if triggered.
Take cross-default and cross-acceleration provisions for example, if a company breaches a covenant or defaults on one debt, it can trigger a chain reaction of defaults across all its debt agreements. This can lead to a cascading effect that severely impacts the company's financial stability.
- Cross-default provision - Cross-default clauses state that defaulting on one debt agreement triggers a default on all other debt agreements.
- Cross-acceleration provisions - Cross-acceleration clauses mean that if one debt is accelerated, all other debts are accelerated too.
- All asset lien provision: this provision gives the provider the right to seize all of the assets of a startup, should they fail to make repayments.
Or take the material adverse change (MAC) clause and the change of control clauses. Those can result in the lender categorizing an outstanding loan as being in “default” even if the startup has consistently made on-time payments, it can also result in accelerated repayment terms.
- Material adverse change clause - provisions that address significant negative changes in a borrower's financial condition, business operations, or prospects.
- Change of control clause - these address situations where there's a significant shift in the company's ownership or management.
- Investor abandonment clause - this gives lenders the right to declare a loan in default if they believe a startup’s investors will no longer continue to support them.
The impact of breaching covenants, clauses, and provisions
If a startup breaches its venture debt covenants, clauses, or provisions, the lender typically has the right to take various actions, including accelerating the loan repayment, imposing penalties, and even classifying the loan as being “in default.”
The TL;DR here: don’t default on your venture debt facility.
Negotiating and Modifying Covenants, Clauses, and Provisions
Negotiation plays a crucial role in venture debt agreements. By actively engaging in discussions about the applicable covenants, clauses, and provisions, borrowers can shape the agreements to better align with their short and long-term business objectives.
Borrowers should negotiate the terms associated with the covenants, clauses, and provisions during the initial stages of the loan agreement negotiation. It's essential to communicate openly about the concerns you have with the restrictions being imposed on your startup. Focus on the impact that these items will cause on your business, and why avoiding them is beneficial to both the lender and your bottom/top line.
The venture debt covenants, clauses, and provisions to avoid
These are the most common covenants, clauses, and provisions to avoid when negotiating your next venture debt deal. While the reality is that you won’t be able to avoid all of them, avoiding even one or two can have a major impact on your startup if things go sideways. Review the sections above for an overview of what each of these items means.
- #1 - Cross-Default Provision
- #2 - Cross-Acceleration Provision
- #3 - Investor Abandonment Clause
- #4 - Maximum loan-to-value ratio
- #5 - Capital Expenditure Covenant
Final thoughts on venture debt covenants, clauses, and provisions to avoid
Venture debt covenants, clauses, and provisions serve a valuable purpose: protecting lenders from default and helping startups maintain sustainable growth trajectories. They can also be detrimental to startups that have lumpy revenues, or those that have a bad quarter (who hasn’t). Being forced to prematurely pay back one loan is bad enough, imagine being forced to pay back all of them at the same time due to a simple provision—that would be soul-crushing. That’s why it's so important to understand what terms you are agreeing to and how can they can impact your startup if things don’t go as planned before you sign on the dotted line. That's why it's also important compare and negotiate the terms in your venture debt term sheet.
We’re by no means legal professionals, and this guide by no means legal advice, but if you’d like an extra set of eyes (or hands) reviewing your term sheets, or if you have additional questions about venture debt covenants, clauses, or provisions, we’d be happy to help out. Send us an email at firstname.lastname@example.org and we’ll be in touch within 48-72 hours.