Debt funding covenants – What you need to know

Fiona King HNH

Fiona King, Debt Covenants: What you need to know

What is a Debt Covenant?

A Debt Covenant is simply an agreement made with your funder to adhere to certain financial and operational measures until the debt is repaid. They allow your funder to monitor its investment in your business and are set out in your funding agreement.

In understanding funding covenants, it is important that business owners know what to look out for in order to assess what impact they may have.

The implications of triggering a funding covenant can range from an uncomfortable conversation with your funder, a fee becoming payable or a renegotiation of terms in full or part. At HNH, our debt funding experts work with clients and funders to ensure that covenants strike the balance of allowing the funder to monitor its investment whilst not restricting the ability of the management team to run the business effectively.

Debt covenants typically fall into 3 categories:

  1. Financial

Your funder is focused here on the ability of the business to continue to service debt. As such, covenants are designed to give an early warning indicator that a business may struggle to service debt in the future.

Financial covenants tend to measure key metrics such as cash generation available for debt reduction (sometimes called EBITDA – Earnings before Interest Tax and Depreciation, adjusted for business specific items such as promoter drawings and working capital).

What to look out for:

  • Ensure the covenant has sufficient headroom to allow normal fluctuations in activity;
  • Timing of measurement – especially if you have a cyclical or seasonal business. 
  1. Information provision

This usually relates to the provision of financial information, typically audited financial statements and management accounts but can also include business specific items such as debtors’ ledgers or stock information.

What to look out for:

  • Format, frequency and deadline for submission – Do you prepare the information requested as a matter of course or will you have to employ someone to do it (and hence incur a fee)? If you outsource the preparation, will it be available within the covenanted 30 / 60 / 90 days after period end?
  1. Restrictive

This category contains covenants that are designed to protect your funder from a change in the risk profile of the business, unexpected calls on cash or diminution of assets.

Restrictive covenants typically relate to: dividends, drawings, capital expenditure, changes in shareholding, raising additional debt, providing security to another funder, making loans to third parties or directors’ remuneration.

What to look out for:

  • Restrictive covenants should not prevent the normal running of the business. It is therefore critical at the outset that provision is made within the funding covenants to for example, pay a certain level of dividend or permit capital expenditure, if that is what the business needs to do to continue its normal operation.
  • Restrictive covenants should also not penalise or discourage out-performance. For example, if covenants include a directors’ remuneration cap and the business wishes to reward employees for out-performance, it is important that provision is made within the funding documentation to permit this.

When selecting the most appropriate debt funding partner, it is therefore imperative that covenants and specifically the extent to which they impact upon your business is given equal priority to pricing.