Venture debt financing agreements often include covenants and restrictions designed to protect the lender’s interests and ensure the borrower’s financial stability. These covenants can be financial or non-financial in nature, and they help lenders monitor the startup’s performance and manage their risk exposure. Here are some common covenants and restrictions associated with venture debt financing:
- Financial Covenants: These covenants require the borrower to maintain specific financial metrics or ratios to ensure the startup’s financial health. Common financial covenants include:
a. Minimum cash balance: The startup must maintain a specified minimum cash balance in its bank account. b. Revenue or EBITDA milestones: The company must achieve certain revenue or earnings targets within a given timeframe. c. Debt service coverage ratio: This ratio measures the startup’s ability to meet its debt obligations, and the borrower must maintain a specified minimum ratio.
- Negative Covenants: Negative covenants restrict the borrower’s actions, limiting their ability to engage in certain activities without the lender’s consent. Examples include:
a. Restrictions on additional debt: The startup may be prohibited from taking on additional debt or may require the lender’s approval to do so. b. Restrictions on equity issuance: The borrower may be limited in its ability to issue new equity or may need the lender’s approval for specific equity transactions. c. Dividend restrictions: The startup may be prohibited from paying dividends to its shareholders while the venture debt is outstanding. d. Asset sales and acquisitions: The borrower may need the lender’s approval for significant asset sales or acquisitions to ensure the startup’s financial stability.
- Affirmative Covenants: Affirmative covenants require the borrower to take certain actions, such as:
a. Providing regular financial statements: The startup must regularly submit its financial statements, budgets, and other financial information to the lender for review. b. Maintaining proper insurance: The borrower is required to maintain appropriate insurance coverage to protect against various risks. c. Compliance with laws and regulations: The startup must comply with all applicable laws and regulations relevant to its business operations.
- Change of control provisions: These provisions require the borrower to seek the lender’s approval in the event of a significant change in the company’s ownership or management structure. This could include a merger, acquisition, or management shakeup.
It’s essential for startups to carefully review and understand the covenants and restrictions included in their venture debt agreements. These provisions can impact the company’s operational flexibility and decision-making. By being aware of and actively managing these covenants, startups can maintain a healthy relationship with their venture debt lenders and minimize the risk of default or other negative consequences.