A financial covenant is a company performance threshold placed into a loan agreement by the lender. A loan funding a leveraged buyout, for example, may require the borrower to generate cash flow of at least $10 million. The lender will ask for this knowing that of the $10 million cash flow, a portion will be used to pay taxes, to pay interest, to pay down principal and a portion will pay for capital expenditures needed to maintain and grow the business. Anything left over provides a buffer to protect from a downturn.
If the company breaches the financial covenant, the lender can call an event of default which can make the loan due and payable immediately. The effect is to give the lender a seat at the table discussing the company’s plan to fix the performance.
Venture lending is different because startups don’t often have free cash flow. Any excess cash is reinvested into growing the business – typically hiring more staff. Most startups burn cash, some until well after they make it all the way to a successful IPO.
It’s difficult to set a financial covenant for a company burning cash. What’s the right measure? The level of burn? If the company is going to drive off a cliff, driving a little bit slower is maybe helpful but not really. The level of cash? The company wants to borrow the money to be able to spend it, so setting a minimum level of cash reduces what can be spent.
Faced with this issue, venture lenders and VCs have settled on a model where the loans typically have no financial covenants. Clearly this approach is not for everyone which is why only a handful of banks and funds lend in this fashion.
Rather than taking comfort from the financial covenant as protection, the lender relies on its relationship with the venture investors, the continuing principal repayments and its ability to choose borrowers that will continue to grow and attract capital.
The lack of a financial covenant is one example of how venture loans differ from traditional loans and why this market is a small group of specialists.