If you’re VC-backed, you might well have taken some venture debt to top up your last financing round. If you’re PE-backed, it’s probable that your PE sponsor took a material amount of debt — e.g., 1-2x ARR — to help finance the acquisition.
Either way, if you’re an enterprise software startup, there’s a good chance there is some debt on your balance sheet.
Debt providers typically aren’t very attention demanding. They don’t require board seats and they usually don’t ask for board observer rights. Sure, they want detailed monthly financial reporting, but your company is producing those reports anyway and it’s easy to add them to the distribution list. So debt providers don’t necessarily get a lot of mindshare from the executive team and board.
If you have debt, here’s my simple advice on managing it:
- Ensure covenant compliance tests are on featured prominently on your one-page key metrics dashboard that accompanies every draft operating plan and is presented at every QBR. This keeps covenants top-of-mind, where they need to be. Covenants are, simply put, existential.
- Try to use debt providers who already work with your investors. This will provide your investors with some leverage if things get dicey. Think: “if you call this loan, you will never do business with our portfolio again.” While such words are more impactful from a relatively big customer, they are also not by any means some kind of invincibility shield.
- Call when you’re in the yellow zone. Don’t wait until you trip covenants to have a conversation with your debt provider. There are a lot of other options besides calling the loan (e.g., refinancing) and it’s best to discuss them while you’re on the warning track, not against the wall.
- Build a relationship with your debt provider. As the saying goes, “build relationships before you need them, because by the time you do, it’s too late.” Return their calls quickly. Check in when not strictly necessary. Offer to do reference calls on new deals. Or, speak at their executive dinners. Say yes to the invitation to their baseball box. Appear as a guest on their podcast. Show them the respect you should show someone who just might be in a position one day to bankrupt your company. Because they are.
When having conversations with your debt provider, think of covenants in two ways:
- In the literal sense, they are part of the contract that you made for your debt. If you break one, you’re in breach of that contract, and they can take whatever remedies the contract provides.
- The intent of most covenants is to ensure the lender gets paid back. They serve as an early warning system to alert the lender of potential trouble. So, e.g., if you had a big deal slip from 9/30 to 10/05 and that threw off your required Q3 liquidity ratios, then you’ve already corrected the problem within two weeks. Hopefully, that calms repayment concerns.
Remember the lender is not only trying to see if you can honor your word, but more importantly, to see if there’s any incremental repayment risk.
Finally, remember that while covenants are black-and-white tests, what to do when they’re breached is not. The debt provider has a lot of different cards to play, and the vast majority of debt providers are not in the “loan to own” business, so they have no desire to take control of your company. The cards they choose to play will be not only a function of the business situation, but of existing relationships and people.
Which is why I always say that your CFO should be the customer testimonial on your debt provider’s homepage. Who wants to call that loan?
(Thanks to Ian Charles for teaching me this principle back in the day.)
