Venture Debt Covenants & 2020 Market Shock

Written by Yair Geva and Yuval Zilber.

In light of the 2020 Market Shock and given the events surrounding the COVID19 Outbreak, we wanted to revisit in this quick post some of the issues that may arise with respect to venture debt covenants in the context of financial crisis.

In “Times of Peace”, venture debt is another useful method of financing your startup. Venture debt includes a mid term loan to the company that is repaid over time, as opposed to an investment in exchange for shares. The loan is typically accompanied by equity kicker — a right to invest in the company’s equity (typically small amounts). Some of the leading venture debt institutions for Israeli related startups, in the US, Israel or Europe, are Silicon Valley Bank, Comerica, Western Technology Investment, Inc. and others.

Typical venture debt agreements often include restrictive covenants imposed on the borrower. Given the 2020 market shock, it’s critical for borrowers to pay special attention to such covenants. Breach of covenants constitutes an event of default, which results in acceleration of repayment obligations and realization of pledges.

There are three types of major covenants: Affirmative Covenants, Negative Covenants and Financial Covenants.

Affirmative covenants, otherwise known as positive covenants, typically require the company to take specific measures in order to operate in a suitable way. This may include keeping and reporting regular financial records, maintaining insurance policies, and generally taking appropriate steps to make sure the business is running smoothly and is in a generally stable condition. The borrower is also required to provide the lender with information, mainly financial information, business plans, etc.

Negative covenants take a different tack. These covenants usually demand that the company obtain the lender’s approval for certain activities, such as paying dividends, orchestrating financing deals, selling assets, mergers and acquisitions, and more. These restrictions are put in place to ensure the borrower’s ability to repay the loan, but sometimes they create a burden and interfere with the regular course of business.

Financial covenants, though not as common, may include, among others, financial targets that the borrower has to meet based on goals and estimates stipulated in the loan agreement, limits on the amount of credit the borrower can have, and maintaining a ratio of assets to debts.

Some tips in regard of maintaining compliance with covenants:

First, to the extent required, borrowers should aim to seek amending the covenants before a default is triggered, rather than requesting a waiver of a default after a covenant is breached. In order to accomplish this, borrowers need to assess the situation in terms of the effect the crisis has on the company’s finances (i.e., business revenue, cash flow, etc.). In addition, the borrower should try to foresee which covenants might be at stake of default, and what effect those might have on other agreements.

Second, if the company is going to request covenant relief, special attention should be paid as to what type of relief is needed; which covenants are going to be harder to comply with, if a short term plan is needed or a long term one. Borrowers that seek covenant relief should be prepared to give something in return, e.g., new covenants, increased information rights, or increase of fees. To do that, borrowers should think creatively, know the lender and recognize its special goals and interests.

Third, given the circumstances, lenders will want to observe the borrowers’ activity more closely, and seek to enforce the positive covenants more attentively. To ease the mind of the lenders, borrowers should ensure that their business plans are adopted to the new economic environment and challenges, and that their projections reflect downside scenarios.

Fourth, the borrowers might need to operate not in the ordinary course of business, and hence the lender’s approval for certain actions might be required. Such actions may include, for example, an increase of the credit line from the bank, and pledge of assets to secure the debt.

Furthermore, financial covenants should be observed very closely at the moment. Companies may find it challenging or impractical to observe financial covenants given to lenders. Borrowers should take measures to ensure that contact with the lender is not compromised, and that they maintain a healthy and communicative relationship with their lenders.

Finally, in times of economic crisis, directors should take into account that when a company is in the zone of insolvency, fiduciary duties shift to creditors. When making decisions, directors should consider the interest of the lenders more attentively, notwithstanding the scope of the covenants included in the financing documents.

For further information, please contact:

Yair Geva, Head of Hi-Tech, gevay@hfn.co.il

Yuval Zilber, Partner, zilbery@hfn.co.il