Capital Structure And Covenants

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name: capital-structure-and-covenants
description: Decides how the business is financed and what that financing then requires of it — debt versus equity, weighted average cost of capital as a hurdle rate, how much leverage cash flow can carry, and the financial, affirmative and negative covenants, definitions, test dates and cure rights that come attached. Use this to evaluate a financing option, set an investment hurdle, check whether a planned decision will trip a covenant, or work out what a lender can do when one breaks.
---

# Capital structure and covenants

Financing is not only where the money comes from. It is a set of ongoing constraints that will
shape operating decisions for as long as the facility exists, and most of those constraints are
discovered late.

## Cost of capital sets the hurdle, so compute it rather than choosing a round number

Weighted average cost of capital blends the after-tax cost of debt and the cost of equity in the
proportions actually used. It is the rate an investment has to clear before it creates value.

Debt is cheaper than equity — the rate is lower, the interest is deductible, and the claim is
senior. That cheapness is exactly why leverage is tempting, and why the temptation needs a limit
set in advance. Equity has a cost even though nobody writes a check for it; treating it as free
is how capital gets consumed by projects that never earned their keep.

## Size leverage to the bad case, not the plan

Leverage amplifies returns on equity and amplifies losses, and the losses arrive first because debt
service does not wait for recovery.

Capacity is governed by the stability of cash flow, not by an industry average ratio. A predictable
subscription business carries debt that a project business with lumpy collections cannot. The
question is never "can we service this at plan" — it is "can we service this at the plan we would
be embarrassed to show anyone."

## Covenants are where financing becomes an operating constraint

- **Financial covenants** — leverage ratio, interest coverage, fixed charge coverage, minimum
  liquidity, sometimes a minimum earnings floor. Tested quarterly in most agreements.
- **Affirmative covenants** — what you must do: reporting by a deadline, audited statements,
  insurance, notice of material events.
- **Negative covenants** — what you may not do without consent: additional debt, liens, asset
  sales, distributions, acquisitions, change of control.

**The definitions matter more than the levels.** Earnings in a credit agreement is a defined term
with its own permitted add-backs and its own caps, and it will not equal the figure in your
management accounts. Two facilities at the same headline ratio can allow very different behavior.

**Model covenants forward at every material decision.** A hiring plan, a capex commitment, or an
acquisition can trip a ratio two quarters out while looking affordable this quarter. Headroom at
each future test date belongs in the forecast, not in a separate spreadsheet nobody opens.

## When a breach is coming, the timing of the conversation is the whole outcome

Approach the lender before the test date. A waiver requested in advance is a negotiation; a breach
discovered afterward is a default, and the difference in leverage between those two positions is
enormous.

Know what the agreement gives you before you need it: cure periods, grace periods, whether an
equity cure is permitted and how often, and whether cross-default provisions pull other agreements
in behind this one. Consequences escalate rather than arriving all at once — a fee, then a rate
step-up, then tightened covenants, then a cash sweep, then acceleration.

## Never

- Sign a facility without modeling its covenants against the downside case.
- Read a covenant level without reading the definitions it depends on.
- Arrive at a test date without already knowing the number.
- Treat equity as costless because no payment leaves the account.