Covenants in a credit agreement are a set of rules you agree to live by, which includes a set of things you will do (affirmative covenants), a set of things you won’t do (negative covenants), a set of things you’ll provide the lender (information covenants) and financial measures you will attain (at or better than required levels), which are financial covenants.

Compliance with these credit agreement covenants is crucial, as they were negotiated in good faith at the time you were borrowing and if you were given good advice or were not in distress at the time you negotiated the terms, you should have a “market terms” agreement to live by.

As a CFO, or more broadly a borrower in general, you should be familiar with these covenants at a very close level and avoid violating any of them at (nearly) all costs. We’ll elaborate on the “nearly” point later – for now assume we mean full compliance is required.

Credit Agreement Covenants: Step by Step:

1.) Make a list! In Excel, or whichever application you find easiest, copy/paste or write down in your own words the things you can and cannot do, or must do on a periodic basis to comply with your covenants.

2.) Pay attention to dates! The period you have to give a first set of audited financials in year 1 may not be the same as year 2, the number of days to provide financials on a monthly or quarterly basis may change after some initial period, the due dates for a budget or the dates required to deliver compliance certificates may change – don’t miss these dates (it’s amateur hour if you do, honestly, and the credibility hit may be worse than the fact it happened, assuming you are performing well and not in default anywhere).

3.) Your credit agreement covenant calculations and credit stats are something to monitor religiously. These are not just numbers to know when you’re close to covenant thresholds. You should determine if the credit package you have is right for you or outgrown, or for some reason otherwise not the right financing package for your next phase of growth or evolution (in reality, you’ll be working closely with your PE sponsor, etc. on this topic and they can help you navigate through all of it).

4.) Build a model. Know your NLR (Net Leverage Ratio, which is Net Debt/EBITDA), FCCR (Fixed Cost Coverage Ratio), Minimum Liquidity, etc…on a quarterly basis, using both your agreement specified minimums and your financial forecast. Review this monthly along with your normal financial close package to avoid being surprised – a proper update if the model is well built should take no time and honestly it’s just good housekeeping.

5.) Affirmative and Negative Covenants are Key. Don’t borrow money you’re not allowed to borrow, put money in bank accounts you open that aren’t under supervision of lenders (if that is required), perform acquisitions that exceed the level of permitted acquisitions, or perform other activities which violate any of the terms within the enumerated lists that are found in these credit agreement sections.

Again, read through your credit agreement covenants carefully. Review them periodically to ensure that current and new team members understand them. Build schedules and calendars that are easy for normal (non-lawyer) people to understand and use those as ways to communicate covenants. Before you do, a final check with the attorneys who helped you negotiate the agreement would be a good idea, or at a minimum anyone you are working with at the PE sponsor – an associate or VP who probably knows every word in the agreement! In a next post we’ll talk about what happens when you can’t comply for reasons of company performance…a particularly hot topic these days…