Venture Debt Covenant

What covenants are typical in venture debt?

Typical venture debt covenants are a liquidity or minimum-cash test, a cash-concentration requirement that keeps the money at the lender, restrictions on additional debt and liens, a negative pledge or lien on intellectual property, insurance and collateral-maintenance obligations, and monthly reporting with a signed compliance certificate.

The four families of covenant

Venture loan documents do not read like leveraged-loan documents, because there is no EBITDA to test. Venture Lending and Leasing VIII's own registration statement describes the standard package as representations, warranties, covenants and events of default that are customary for commercial transactions of this type and size, and then names the substance: restrictions on additional debt, covenants to maintain the collateral and keep it adequately insured and free of liens, prohibitions against selling or disposing of the assets except under specified conditions, and acceleration provisions that make the loan immediately due and payable on events of default including missed payments, insolvency and covenant breach.

Sort them into four families.

• Financial covenants. One or two tests, almost always about liquidity rather than earnings.
• Affirmative covenants. Deliver monthly financials and a compliance certificate, keep insurance, maintain the collateral, keep primary operating and securities accounts at the lender under an account control agreement.
• Negative covenants. No additional indebtedness, no liens, no asset sales outside the ordinary course, no dividends or distributions, no change of control, limits on investments and subsidiaries.
• Intellectual property treatment. Either the lender takes a lien on substantially all assets including the intellectual property, or it takes a lien on everything else plus a negative pledge on the intellectual property. That registration statement describes exactly that fork for the fund's growth and working-capital loans.

The two families that actually break deals are the liquidity covenant and the cash-concentration requirement. Everything else is boilerplate the company can live with.

How the liquidity covenant is built

The modern venture liquidity covenant is a ratio of cash to burn, not a dollar floor, although dollar floors still appear.

KORU Medical Systems and HSBC Ventures USA define Remaining Months Liquidity as the aggregate amount of the borrower's unrestricted and unencumbered cash and cash equivalents maintained with the bank and its affiliates, divided by the borrower's Adjusted EBITDA for the most recent trailing three-month period divided by three, expressed as a positive number. Section 6.9 then requires Remaining Months Liquidity greater than twelve, tested on the last day of the month in which the testing event occurs and monthly after that, with a carve-out: in any month where trailing three-month Adjusted EBITDA is positive, the borrower is deemed compliant.

Three design details in that clause matter more than the number twelve.

• Only cash held at the lender counts. Money parked at another bank is invisible to the test.
• The denominator is a trailing three-month average, so a single heavy month drags the ratio for a quarter.
• Profitability switches the covenant off, which is the lender saying it only cares about runway while runway is the risk.

The older Hercules-style structure uses a dollar floor with step-downs tied to milestones. In its amended loan agreement with X4 Pharmaceuticals, the minimum-cash covenant required unrestricted cash in controlled accounts of at least the greater of $30,000,000 or six times a defined liquidity metric; after the borrower achieved Performance Milestone III the floor dropped to the greater of $20,000,000 or three times that metric; and once the FDA approved the borrower's lead product for its target indication, the requirement was extinguished entirely.

Covenants also get deleted. When MINDBODY amended its loan agreement with Silicon Valley Bank in January 2018, the amendment deleted the revenue covenant outright while extending the revolving line. Covenant relief is a normal part of the relationship, not an admission of distress.

A worked example of a liquidity covenant test

Take the KORU-style formula and a hypothetical borrower. Assume unrestricted cash held at the lender of $30,000,000 and trailing three-month Adjusted EBITDA of negative $7,500,000. All figures here are hypothetical.

• Step one, monthly burn. $7,500,000 divided by 3 equals $2,500,000 per month.
• Step two, the ratio. $30,000,000 divided by $2,500,000 equals 12.0.
• Step three, the test. The covenant requires Remaining Months Liquidity greater than twelve. Exactly 12.0 is not greater than twelve, so the borrower fails.

Two routes back into compliance, from the same starting point.

• Cut burn. Bring trailing three-month Adjusted EBITDA to negative $6,000,000, so monthly burn is $2,000,000 and the ratio is $30,000,000 divided by $2,000,000, which equals 15.0. Compliant.
• Add cash. Hold $31,500,000 against the original $2,500,000 monthly burn: $31,500,000 divided by $2,500,000 equals 12.6. Compliant.

Re-add the three results. 7,500,000 / 3 = 2,500,000; 30,000,000 / 2,500,000 = 12.0; 6,000,000 / 3 = 2,000,000 and 30,000,000 / 2,000,000 = 15.0; 31,500,000 / 2,500,000 = 12.6. The lesson is that the covenant is satisfied by burn discipline as readily as by fundraising, and burn is the variable the company controls in the month the test lands.

Where the covenants show up in documents

In a loan and security agreement, the affirmative covenants and the financial covenant sit in one article and the negative covenants in the next. KORU's financial covenant is Section 6.9, titled Financial Covenant, Remaining Months Liquidity. In the Hercules-form agreement with X4, the minimum-cash covenant is Section 7.22, titled Minimum Cash.

The compliance certificate is the document that decides whether you breached. KORU's certificate sets out the arithmetic as numbered lines: line A is cash held with the bank and its affiliates, line B is trailing three-month Adjusted EBITDA, line C is line B divided by three, line D is line A divided by line C, and the certificate asks whether line D is greater than twelve. The same certificate carries a schedule listing every deposit and securities account, which is how the cash-concentration covenant is policed.

Read the remedies section next, because it can quietly soften the whole covenant. KORU's agreement provides that if an event of default occurs solely under Section 6.9, the bank will not declare the term loan advances immediately due and payable. That single carve-out converts a liquidity trip from a fatal event into a negotiation about the revolver.

Common mistakes

Counting all cash. If the covenant reads "maintained with Bank and Bank's Affiliates," a treasury sweep into a money market fund elsewhere can put the company in breach while its total cash is unchanged.

Reading the covenant without the definitions. Adjusted EBITDA, unrestricted cash and cash equivalents are all defined terms, and the definitions do the work. A covenant that looks generous with a narrow cash definition is tighter than a strict-looking covenant with a broad one.

Forgetting the test date. A monthly covenant tested on the last day of the month rewards a company that times a capital call or a receivable collection into that day, and punishes one that pays annual insurance premiums on the last business day.

Ignoring the events of default other than covenants. Insolvency, cross-default, judgment defaults and material adverse change clauses trigger the same acceleration remedy as a missed ratio, and are harder to model.

Treating a granted amendment as permanent. Deleted or waived covenants are usually traded for something, such as a higher end-of-term charge, a shorter amortization period or more warrants.

How it relates to adjacent terms

Affirmative and negative covenants are the two halves of the package described above, and in venture loans the negative covenants on additional debt and liens are what make a second lender hard to bring in later.

A material adverse change clause is the covenant with no number in it. Companies argue about the liquidity ratio and then discover that the lender's broader discretion is the operative constraint.

Runway is the covenant expressed in the founder's own language. A twelve-month Remaining Months Liquidity test is a lender writing down, in a contract, that it wants twelve months of runway at all times, which means the company's effective usable cash is less than its bank balance.