Covenants, and what breaching one actually means
The tests a lender sets, how they are measured, and what happens on the day you fail one.
In brief
- A breach is a negotiation, not an ending — but it is a negotiation you enter having lost your leverage.
- Headroom matters more than the level. Ask what a 15% miss does to the test.
- Tell the lender before the test date, not after.
A covenant is a promise about the state of the business, tested at intervals. Break it and the lender acquires the right to act — which is not the same as acting.
The three you will actually see
What headroom means
The level is less informative than the distance between the level and your plan. A minimum ARR test set at 90% of plan gives you a bad month before it bites. At 75% it gives you a bad half-year. Model the test against your downside case rather than your base case, because the base case is not what the covenant is for.
The day you breach
In practice the lender has four options, in ascending order of pain: waive it, waive it for a fee, reset the covenant in exchange for something — more warrants, a higher margin, an equity injection from your sponsor — or accelerate. Acceleration is rare, because a lender who takes the keys owns a business it cannot run. The middle two are the realistic outcomes.
Continue learning
Warrants and equity kickers
Why lenders take equity, and what it costs you.
Continue