What is a springing covenant on an asset-based line?

What “springing” means

A maintenance covenant on a cash-flow loan is tested every quarter whether anything has changed or not. A springing covenant is written into the agreement from day one, with a level and a definition, but it has no effect until a condition is met. On an asset-based line, that condition is almost always excess availability: how much more the business could borrow today, given its borrowing base, its outstanding loans, its letters of credit and any reserves.

The clause typically reads something like: if excess availability is less than the trigger amount at any time, the borrower shall maintain a fixed charge coverage ratio of not less than the stated floor, measured for the most recent twelve-month period for which financial statements have been delivered. The ratio then keeps being tested until availability has stayed above the trigger for a set number of consecutive days.

So there are two moments that matter. The first is the day availability dips below the trigger, which can happen in the middle of a month because of a large payroll, an inventory buy or a customer that paid late. The second is the look-back: the test is run on figures that already happened. By the time the covenant springs, the business cannot change the twelve months it is being measured on.

A springing covenant does not ask how the business is doing today. It asks how the last twelve months looked, on the day liquidity got tight.

Why asset-based lenders use it

An asset-based lender is repaid, first, from the collateral. While receivables and inventory comfortably exceed the loan, the lender is protected by the borrowing base itself: it advances a share of eligible receivables, commonly 80% to 90%, and inventory at up to 85% of net orderly liquidation value, and it watches those assets through certificates and field exams. A cash-flow covenant adds little while there is plenty of room between the loan and the collateral.

When availability shrinks, the picture changes. Thin availability means the business is using nearly everything the collateral supports, and the lender's cushion against dilution, fraud or a collapse in inventory value is small. At that point the lender wants evidence that the business generates enough cash to pay its fixed charges without borrowing more. The springing covenant is how it asks for that evidence, only when it needs it.

That design is why asset-based lines suit businesses that a cash-flow lender would turn away: companies with lumpy earnings, a recent loss, or a turnaround underway. It is covered in more depth in asset-based vs cash-flow lines of credit and asset-based lending for unprofitable companies. The trade is that the covenant can spring at the worst possible moment.

The parts of the clause, and what springs with it

Four terms decide how a springing covenant behaves. Read each one before signing, because two agreements with the same headline trigger can behave very differently.

• The trigger. Stated as a fixed dollar amount, as a share of the commitment or the borrowing base, or as the greater of the two. A trigger tied to the lower of the commitment and the borrowing base moves as collateral moves, so a seasonal drop in receivables can lower availability and the trigger at different speeds.
• How availability is measured. At any time, on a single day, or as an average over consecutive days. "At any time" means one bad afternoon counts.
• The test itself. The fixed charge coverage floor and, more importantly, the definition of fixed charges and of EBITDA. Whether unfinanced capital spending, cash taxes and distributions are subtracted decides whether a profitable business passes.
• The release. How long availability must stay above the trigger before testing stops. A release measured over a long run of consecutive days keeps the covenant awake well after the squeeze ends.

The same availability trigger, or a nearby one, often switches on other things. Many agreements move the borrower into full cash dominion (collections sweep straight to the loan), require weekly rather than monthly borrowing base certificates, and allow more frequent field exams and appraisals. The comparison of full and springing cash dominion covers that part. A business that crosses the trigger usually feels all of them at once.

A worked example

A distributor has a line with a commitment of 10,000 and a borrowing base of 8,500. It owes 6,800 and has a letter of credit of 200 open for a supplier, so excess availability is 1,500. The springing trigger is 1,250.

In its busy season it buys inventory ahead of a large order and draws 400 more. Most of that inventory is in transit and not yet eligible, so the base barely moves. Availability falls to 1,100, below the trigger, and the fixed charge coverage test springs. It is measured on the last twelve months:

The business was profitable and growing. It fails because, in the months before the squeeze, it bought a truck and a forklift from cash and paid its owners a distribution beyond their taxes, all while the covenant was asleep. Had the equipment been financed separately, through an equipment loan the line permits, the 700 would not have been unfinanced capital spending. The new loan's payments would have joined fixed charges, but spread over several years rather than taken in one, and the ratio would very likely have cleared the floor.

Two lessons follow. First, what the business does while the covenant is dormant decides whether it passes when it wakes. Second, the trigger is usually crossed by an operating decision, not by bad results, so the finance team needs to know where the trigger is before the purchasing team places the order.

How to keep it from springing

The covenant is only a risk if availability falls below the trigger. Managing it means managing availability, which is a forecasting job more than a negotiating one.

• Forecast availability, not just the loan balance. Project the borrowing base month by month from expected receivables and inventory, subtract expected borrowings, and draw the trigger on the same chart. Look for the seasonal low point.
• Keep receivables eligible. Receivables more than 90 days past invoice typically fall out of the base, and any customer above the concentration cap, commonly 20% to 25% of eligible receivables, adds nothing past the cap. Chasing one slow account can be worth more availability than a new customer. See eligible vs ineligible receivables.
• Time the discretionary cash. Distributions, cash-funded equipment and prepayments to suppliers all reduce availability and, in the fixed charge test, the numerator too. Schedule them after the seasonal peak, not before.
• Finance long-lived assets separately. Capital spending funded with its own loan usually does not count as unfinanced capital spending. Check that the line's debt and lien baskets allow the equipment financing first.
• Compute the ratio every quarter anyway. Even while the test is dormant, run it. If the trailing ratio is below the floor, the business is one tight month away from default and should hold more availability in reserve.
• Watch reserves. An availability reserve for rent, taxes or dilution lowers availability without any change in the business. Ask what the lender may reserve for, and on what notice.

What to negotiate before signing

Springing covenant terms are set at the term sheet, when the lender is competing for the deal. After closing, the borrower is asking for a favor. The terms worth negotiating are the ones that decide how often the covenant can realistically wake:

• A trigger sized to the business's real seasonal low, from a monthly forecast, not a round number.
• Availability measured over several consecutive days rather than at any time, so a one-day dip from a payroll does not count.
• A fixed charge definition that excludes capital spending financed with other debt and allows tax distributions for pass-through owners.
• A short release period once availability recovers.
• An equity cure, so the owners can contribute cash to fix a miss rather than depend on a waiver.

Transparent's book includes 235 lenders that write asset-based loans and lines, bank and non-bank, and their springing triggers and definitions differ. The financing model in the lender package forecasts the borrowing base and availability month by month and marks the trigger, so the borrower can see in advance which months are tight and compare term sheets on how often each one's covenant would actually spring. If a covenant has already sprung and failed, what to do after a covenant breach covers the options.