Knowing the lingo of business transactions, particularly in the world of mergers and acquisitions (M&As), is one of the keys to a successful outcome. Expressions such as business valuation, deal structure and due diligence are commonly used, and knowing these terms, among others, is vital. One important term to know about is debt covenants.
What Are Debt Covenants?
A covenant is a legal and financial term that is commonly used in business transactions. It’s a promise that is applied in an indenture or other formal debt agreement that states whether certain activities will (or will not) be carried out. Covenants are legally binding clauses in any transaction, and if they are breached, it can cause compensatory or quite possibly some other type of legal action. Covenants that permit certain activities are considered “affirmative covenants,” while those that include restrictions are considered “negative covenants,” which is described in more detail below.
Debt covenants (sometimes referred to as “financial covenants”) are a set of conditions that are commonly used in financial contracts, such as M&As. They stipulate certain rules to which the borrower is either legally obligated or forbidden to undertake. In short, such covenants are a set of conditions that help ensure that the borrower will most likely be able to honor its financial commitments as outlined in the document.
When and Why Are Debt Covenants Used?
At first glance, a debt covenant would appear to put pressure on the borrower, but that isn’t the reason for them. The true nature of debt covenants is to protect the lender by identifying issues in a business that could possibly impair its ability to meet its legal obligations as defined in the contract. Both parties in the transaction benefit from debt covenants as follows.
- The lender: Debt covenants help the lender, mainly by disallowing certain actions by the borrower that can negatively impact the risk for the borrower, which could possibly impair the ability to repay the loan.
- The borrower: The borrower can benefit by having a lower cost of borrowing, as the debt covenants often result in more favorable terms for the borrower, as long as the borrower abides by the restrictions.
Listing of Debt Covenants
There are many types of metrics used by lenders to establish debt covenants for the borrower. These include the following.
- Total assets of the borrower: An obvious observation, but this one tops the list. The net assets of a company are the total of all the assets minus the total of all the liabilities. Naturally, every company strives to have a high total assets number.
- Tangible net worth of the borrower: The borrower also has to have its finances in order. The tangible net worth of a company is basically the same as the total assets as listed above, but minus intangible items, such as copyrights, patents and IP (intellectual property).
- Debt/equity and debt/assets: Similar to the above examples, the ratio of a company’s debt to its equity and assets is an important metric when used to measure the fiscal health of it.
- Dividend payout ratio: This is the payout ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.
- Debt/EBITA, debt/(EBITA — capital expenditures), interest coverage (EBITA or EBIT/interest) and fixed charge coverage (EBITA/[total debt service + taxes + capital expenditures]): These ratios, all dependant on EBITA (earnings before interest, taxes, and amortization), are key metrics when it comes to gauging the financial health of a company.
- Limitations on M&A activity: Putting limits on any M&A activity that may impact cash flow on the part of the borrower (or seller) may indeed impact repayment of the loan amount.
Positive and Negative Debt Covenants
There are positive as well as negative debt covenants that are part of the contract. Exactly as it sounds, positive debt covenants state what the borrower must do; conversely, negative debt covenants list what the borrower is forbidden to do.
Positive debt covenants include the following:
- Maintain a predetermined threshold in certain financial ratios: As mentioned above, having a predetermined number on the important financial ratios is certainly a condition for a positive debt covenant.
- Confirm all accounting is performed in accordance with generally accepted accounting principles (GAAP): The lender (or buyer) must prove that the borrower (or seller) is complying to the GAAP.
- Deliver yearly audited financial statements: The lender (or buyer) must ensure that the financial statements that the borrower (or seller) produces are accurate and present the right picture of the company’s fiscal affairs.
- Document facilities and capital assets are in good working condition: Confirming these valuable assets are working and worth the amount they’re appraised for is a key condition for any company involved in an M&A.
Negative debt covenants include the following:
- Changes in dividend amounts: The amount of dividends paid to shareholders is related to the net income of the company. A change in the dividend payout can greatly affect the borrower’s (or seller’s) ability to repay the loan.
- Sell any assets not specified in the original agreement: The list (and value) of the borrower’s (or seller’s) assets have been recorded in the original agreement, so no sales of these assets is permitted.
- Incur more debt: The borrower (or seller) is not allowed to incur debt of any type beyond that which was stipulated in the original agreement.
- Enter into leases or other financial transactions not specified in the original agreement: Similar to the incurring additional debt example listed above, the borrower (or seller) may not enter into any financial contracts that were not in the original agreement.
Any of these violations may result in the termination of the agreement or in a change in terms.
About Virtual Data Rooms
If your company is involved in (or planning to be involved in) any M&A activity, a third-party virtual data room (VDR) is required. A VDR is a secure, online repository where all parties involved in the transaction can safely and securely store and share the required documentation. A VDR provider should be a trusted partner in these types of transactions and supply the appropriate tools required. These tools include secure access, enterprise-level encryption, multiple layers of security and user-friendly admin controls.
How CapLinked Can Help
CapLinked, an industry leader in the VDR space, provides all these tools and more and can help save time and money in any of these corporate transactions. CapLinked provides VDRs that include high-level admin controls, document and version management, multiple layers of security and 24/7 customer support. Its user-friendly interface and ability to work on virtually every type of computer or internet-connected device makes CapLinked the best choice for anyone dealing with transactions that include debt covenants. Visit CapLinked today for a free trial.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
CFA Journal – Debt Covenants: Definition, Types, And How does it work?
Avocadougtoast.com – What are Debt Covenants? — How They Work