Loan Structure and Terms: Focus on Covenants

Covenants are conditions or agreements the borrower must adhere to during the life of the loan. They are critical in mitigating risk, ensuring compliance, and providing early warnings of potential financial distress. Covenants are broadly categorized as financial covenants and operational covenants, let’s explore each one individually.

1. Financial Covenants

These are quantitative conditions tied to the borrower’s financial health. They are often structured around key financial ratios or metrics and serve as triggers for lender intervention if breached. Common financial covenants include:

Leverage Ratio

• Definition: Measures the borrower’s debt levels relative to earnings or equity.
  • Example: Total Debt / EBITDA ≤ 4.0x
• Purpose: Ensures the borrower does not become over-leveraged.

Debt Service Coverage Ratio (DSCR)

• Definition: Ensures the borrower generates sufficient cash flow to cover debt obligations.
  • Example: EBITDA / Total Debt Service ≥ 1.25x
• Purpose: Protects against cash flow shortfalls impacting loan repayment.

Interest Coverage Ratio

• Definition: Assesses the borrower’s ability to pay interest expenses with earnings.
  • Example: EBIT / Interest Expense ≥ 2.5x
• Purpose: Monitors whether operating income comfortably covers interest payments.

Current Ratio

• Definition: Measures short-term liquidity and ability to meet immediate liabilities.
  • Example: Current Assets / Current Liabilities ≥ 1.2x
• Purpose: Ensures sufficient working capital to cover short-term obligations.

Fixed Charge Coverage Ratio (FCCR)

• Definition: Evaluates the borrower’s ability to cover fixed financial obligations, including rent and debt payments.
  • Example: (EBITDA – CAPEX) / Fixed Charges ≥ 1.1x
• Purpose: Ensures adequate buffers for all fixed commitments.

Net Worth Maintenance

• Definition: Requires the borrower to maintain a minimum net worth level.
  • Example: Tangible Net Worth ≥ $10 million.
• Purpose: Prevents erosion of the company’s equity base.

2. Operational Covenants

These are qualitative or non-financial conditions imposed to maintain the borrower’s operational stability and safeguard the lender’s interests.

Reporting Requirements

• Definition: Mandates the borrower to regularly provide financial and operational reports.
  • Example: Quarterly financial statements, monthly AR and inventory reports, and annual audits.
• Purpose: Ensures ongoing visibility into the borrower’s financial and operational health.

Borrowing Base Requirements

• Definition: ABL loans, tie the loan amount to the value of specific collateral.
  • Example: Loan limited to 80% of eligible accounts receivable and 50% of inventory. (these percentages represent traditional banking versus private credit facilities that typically provide higher percentages).
• Purpose: Protects against over-lending by closely linking loan size to collateral quality.

Restriction on Additional Debt

• Definition: Limits the borrower’s ability to incur additional debt without lender approval.
  • Example: No new debt exceeding $1 million without written consent.
• Purpose: Prevents excessive leverage that could endanger repayment ability.

Restrictions on Dividends or Distributions

• Definition: Prohibits or limits payments to shareholders or equity holders.
  • Example: No dividends if DSCR falls below 1.5x.
• Purpose: Ensures retained earnings are used to bolster the company’s financial health.

Asset Sale or Transfer Restrictions

• Definition: Restricts the borrower from selling or transferring major assets without the lender’s consent.
  • Example: No asset sales exceeding $500,000 without lender approval.
• Purpose: Maintains the integrity of the collateral base.

Key Man Insurance

• Definition: Requires the borrower to maintain insurance on critical executives.
  • Example: Life insurance on the CEO for $2 million.
• Purpose: Mitigates the risk of operational disruption due to the loss of key personnel.

Limitations on Capital Expenditures

• Definition: Restricts excessive spending on non-operational or speculative projects.
  • Example: Annual CAPEX must not exceed $2 million.
• Purpose: Prevents cash flow diversion from operational needs and debt service.

Change of Control Provision

• Definition: Requires the borrower to notify or seek approval for ownership or control changes.
  • Example: Loan is callable if more than 50% ownership is transferred.
• Purpose: Ensures the lender’s credit decision remains valid under the existing ownership structure.

Compliance with Laws

• Definition: Requires adherence to all applicable laws and regulations.
  • Example: Maintain compliance with environmental regulations and labor laws.
• Purpose: Minimizes legal risks and potential liabilities for the borrower and lender.

3. Covenant Breach and Remedies

Consequences of Breach

• Loan default declaration.
• Increased interest rates (penalty rate).
• Requirement to cure the breach within a specified period (grace period).
• Acceleration of loan repayment.

Covenant Waivers or Modifications

• Lenders may renegotiate terms upon minor or temporary breaches.
• Typically involves additional fees or stricter future covenants.

4. Structuring Covenants in Loan Agreements

Covenants are customized based on:

• Borrower’s financial strength and industry norms.
• Lender’s risk tolerance and loan purpose.
• Type of financing (ABL vs. Cash Flow Loan).

A well-structured covenant package ensures balanced risk management, lender security, and borrower flexibility to operate effectively.

By Todd Vandegrift

Managing Partner @ EdgeWork Capital