No EBITDA? No Problem. Understanding Recurring Revenue Financing

Introduction

Over the last few years, recurring revenue financings have increased in frequency and size as more private credit funds add this product to their toolbox. These deals use traditional leveraged loan terms, but base the covenant model on recurring revenue streams, as opposed to EBITDA for purposes of financial covenant calculations. This enables borrowers who are either pre-EBITDA or which have insufficient EBITDA to support a conventional leverage-based financing to access credit markets that previously were limited to higher cost venture capital sources. Examples include growing tech companies that have a subscriber base for recurring revenue, but do not yet have a cash flow track record to support traditional leveraged finance borrowings. The deals are usually structured to convert from revenue to EBITDA-based covenants and pricing once the business model supports the more traditional approach. Key terms to understand about recurring revenue financings are discussed below.

Documentation, Structure and Pricing

The credit documentation mirrors that of a traditional secured leveraged loan but for the emphasis on recurring revenue over EBITDA in the early stages for core covenants, financial reporting, and pricing. Most of the financing providers competing in this space are private credit funds making unitranche structures more common than syndicated credit documentation. First-priority liens on all assets, particularly key IP, are standard. Deal sizes run the full range of middle market lending with non-amortizing term loans being the bulk of the facilities. Working capital revolvers can be tacked on depending on the lender’s ability to do so. The risk involved in pre-EBITDA financing necessitates a higher equity contribution to support the credit, usually 60% or more of pro forma capitalization. Because of limited cash for debt service, the deals are frequently non-amortizing and include PIK toggles with no excess cash flow sweeps. This can all change following conversion of the covenants, which is discussed further below. Pricing tends to be higher than traditional leveraged lending because of the risk inherent in a growing business model. Still, the pricing is far less than what a borrower would find from venture capital sources. Increased competition in this space has also compressed pricing. Margins can be grid based on revenue ratios and usually convert to lower spreads after the covenants flip to the EBITDA-based model. Financial reporting is more frequent than traditional leveraged loans, with monthly reporting required in addition to quarterly and annual information. In addition to the customary balance sheet, income and cash flow reporting, the information will be tailored to the growing business revenue base and include, for example, reports on subscription rates, customer retention, customer churn, bookings, and similar metrics that support the business plan and budgets.

Covenant Scheme

Financial covenants are primarily focused on recurring revenue and liquidity.

Recurring Revenue. Instead of using EBITDA for leverage and debt service ratios, the financings use recurring revenue, defined to include ongoing subscription, licensing, and other maintenance fee revenue of the business, for ratio testing. Revenue eligibility is limited to fixed payments of a specified term, usually a minimum of 12 months. Prior to conversion, the covenants are usually tested quarterly on a maintenance basis. Recurring revenue can be done on a historical basis, but it is more common for it to be annualized based on recent performance (last fiscal quarter times four and such).

Liquidity. Liquidity measures the sum of the borrower’s unencumbered cash on hand plus undrawn debt capacity (making the revolver more important). This can be tested at all times, on a quarterly or on another target-date basis.

Equity Cures. Equity can be used to cure both types of financial covenants, but having the cure right for the revenue ratios is more common. Unlike most leveraged deals, the contributed equity is used to reduce debt as opposed to increasing revenue. This flips upon conversion to EBITDA-based covenants. Limits on frequency of cures tend to mirror customary leveraged finance.

Cushions. Just like in EBITDA-based leveraged finance, the covenants are set at a cushion to the borrower’s financial model. These cushions typically range from 15-35%.

Other Covenants. Non-financial covenants mirror the same you would see in an EBITDA-based transaction with dollar baskets, as opposed to growers, more common pre-conversion. Overall, the covenants are tighter in the pre-conversion stage, including limiting and/or prohibiting ratio-based restricted payments and restricted debt payments, but some sponsor deals are getting done with more traditional concepts such as starter baskets, free and clear incremental facilities, available amount calculations, and other similar exceptions being included upfront.

Conversion

As noted above, recurring revenue financings are designed to bridge the gap between a business that is growing from a revenue base to stable cash flow. The deals are designed to convert to EBITDA-based covenants once the business can support it. The conversion date is usually set at two to three years after initial funding, but there has been a trend in recent deals to keep the conversion fluid and base it off performance measures and other triggers as opposed to a pre-agreed date. Once converted, however, all of the pre-conversion mechanics discussed above, such as PIK toggles, higher pricing, tighter covenants, etc., fall away and the deal flips to a more traditional EBITDA-based credit and covenant scheme. For larger deals, this usually means flipping to a covenant-lite structure. The conversion feature also justifies the higher pricing involved at the outset as the borrower is getting a built-in, no cost refinancing in the structure.

Conclusion

Recurring revenue financings have become a fully matured credit product providing additional credit sources for borrowers and alternate investment options for lenders. We expect the product to continue to evolve as competition continues and more lenders add this to their underwriting schemes. Please contact any member of the O’Melveny & Myers Finance team if you would like more information. 

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