Recurring Revenue Is Not EBITDA – Key Considerations for Software and Technology Financings

Executive Summary

• When the technology sector became indispensable during the COVID-19 pandemic, investors across the capital structure flocked to tech companies.
• During 2020 and 2021, loan issuances for software and other technology-related companies increased, with recurring revenue deals’ market share and deal quantum expanding rapidly   
• Structuring these recurring revenue transactions requires modification of typical credit facility structures because of the nascent, pre-EBITDA generating nature of many of these borrowers.
• To facilitate successful outcomes for U.S. loan market participants, recurring revenue credit facilities for software companies and tech startups must take into account key differences in financial performance metrics, assets, and operations.

Recurring Revenue Transactions Generally

The COVID-19 pandemic and resulting stay at home pressure and shift to remote work emphasized the critical importance of technology. The U.S. loan market experienced a corresponding sector boom with technology companies eager to exploit the increased demand. While many market participants were eager to provide such funding, some needed to adapt to reflect the unique financial performance metrics, assets and operations in parts of the technology industry. Such credit facilities are often based on recurring revenue instead of EBITDA (at least initially) due to the borrowers’ maturity and cash flows and expenditure needs to that point. Recurring revenue deals share some similarities with other “cash flow” credit facilities, but the devil is in the details. As further described below, some of the key distinguishing features of recurring revenue deals may include various terms that are initially tied to recurring revenue and later to traditional cash flows / EBITDA (such as financial covenants and pricing grids), as well as tech-focused reporting obligations and other covenants addressing intellectual property (IP) and confidentiality matters.

1. Financial Covenants and Definitions

Financial covenants and definitions are fundamental in structuring any credit facility, and are key evaluation criteria for underwriters when making credit decisions. In most cash flow credit facilities, financial metrics are focused on EBITDA and EBITDA-based leverage. However, for tech companies that are still in the startup / early stages, or that otherwise have limited working capital, covenants may instead be based on recurring revenues. The recurring revenue structure gives the borrower the ability to take cash flow from the business and re-invest that cash flow (in sales, marketing, R&D, etc.) rather than repaying the debt. By extension, this allows the company to grow the customer base or develop new IP. However, after this effective “grace period”, cash flow must be sufficient to continue these activities and repay debt.

Recurring revenue deals often start with a minimum liquidity covenant and a debt-to-recurring revenue ratio covenant, and then shift or “convert” to traditional EBITDA-based leveraged covenants, at which point the liquidity covenant typically “falls away”. The shift to traditional cash flow covenants may also include a fixed charge coverage ratio or minimum EBITDA requirement, but this is much more rare. The cash flow forecast presented at underwriting is pivotal in determining when this covenant shift should be required. For the flip to EBITDA-based definitions and covenants to work as intended, the definition of EBITDA also needs to take in account industry-specific issues, such as inclusion of a deduction for capitalized software development costs and appropriate treatment of recurring revenue recognition. Lenders often include an election for a company to flip to these EBITDA-based covenant earlier than required, incentivizing the company with step-downs in pricing and access to increased investment and dividend capacity. Of course, there are some tech companies that do and/or should have traditional EBITDA based covenants out of the gate because they have stable and positive EBITDA levels and enough cash flow to conduct appropriate sales, marketing, and R&D and repay debt when it becomes due.

2. Augmented Reporting Requirements

Most regular way credit facilities contain reporting requirements that are often relatively industry neutral and similar across the board. Annual audited financial statements and quarterly financial statements are typically required, with variations typically dependent upon the credit history and financial performance of the borrower or specific to asset-based loans. However, recurring revenue deals ideally should include additional reporting, especially given the nature of typical recurring revenue borrowers’ businesses and the financial covenant structures in such deals. Further, more frequent reporting is common due to the possibility that the forward-looking and often annualized financial metrics are more susceptible to short-term changes.

Reporting requirements should be tailored to provide lenders with sufficient visibility into the borrower’s operations, plans, and performance. In recurring revenue deals, reporting should cover any matters that impact revenues. Specific reporting might cover items such as (1) subscription billing rate, (2) customer count analysis, (3) booking, (4) customer “churn rate” (or attrition), and / or (5) gross or net retention. Such reporting facilitates the close monitoring of the borrower’s financial performance and operations to determine appropriate financial definitions, covenant levels, and structures. It is critical for the lender to monitor customer churn in recurring revenue deals and this additional reporting helps facilitate that.

3. IP Ownership and Confidentiality Considerations

Generally, affirmative and negative covenants in recurring revenue credit facilities (other than reporting) will be similar to such covenants in other cash flow deals. However, there are critical considerations regarding IP and confidentiality that must be taken into account when establishing such obligations for tech companies. Conducting effective diligence to understand research and development (which employees / consultants are doing this and who is the employer or party to the consulting agreement), corporate and employment structures, licensing and other arrangements between the loan parties and their subsidiaries and affiliates and potential open source usage is pivotal. Lenders first need to determine who legally owns or licenses the IP and which entities in the group are party to revenue-generating contracts. Determining IP ownership may be complicated, particularly for software companies, as applicable IP often is not registered, rendering traditional searches in IP filing offices of limited utility. To further complicate matters, many software companies avail themselves of tax breaks reaped by having foreign subsidiaries own and develop IP, creating additional complexities in structuring loan and security documentation. It is critical to have IP counsel analyze and confirm IP ownership in these deals.

Ideally, all IP will be owned by domestic loan parties and any foreign-owned IP would be legally assigned to domestic loan parties as it is developed. However, if complete domestic loan party IP ownership is not possible, creative arrangements may be required. Financial definitions and covenant structures may need to be adapted, or additional collateral and licensing documentation provided, to protect collateral value and ward off potential leakage and drop-down transactions. At a minimum, recurring revenue credit facilities should ensure that any material IP (and exclusive licenses thereof) be owned or held by the loan parties. Negative covenants and collateral release provisions should restrict transfer of material IP outside of the loan parties (particularly with respect to exclusive licensing) to avoid putting critical assets at risk.

The loan parties should be required to make representations, and the affirmative covenants ideally will require, that all employees, consultants, advisors, etc. assign IP rights to a loan party and maintain “corporate confidentiality” (i.e., keeping such IP confidential and information thereon with the company). Negative covenants ideally will prohibit loan parties, employees and consultants from assigning their rights in any material IP collateral and from disclosing trade secrets and source code, including to prevent such items from becoming open source software.

Key Takeaways

Successful structuring of recurring revenue transactions requires thorough analysis of the borrower’s software products (and the “stickiness” of the customers) and the borrower financials, assets, expenditures and operations. The first step is to carefully evaluate current recurring revenues and projected cash flows and expenditures and to determine which entities are revenue generators, which group members own or license IP, and the relationships between such entities, as well as the entities’ relationships with employees and consultants. Next, this information, together with models and projections, can be used to develop a financial covenant model that provides the tech company borrower with a sufficient, but not overly generous, ramp up period, before the switch to EBITDA based covenants occurs. Of course, as noted above, some tech companies are mature or profitable enough to have an EBITDA based covenant at the start of the deal. Requiring detailed reporting on recurring revenues and/or customer churn can also enable lenders to be more proactive and take needed actions to right the course and protect their interests. Ensuring ongoing compliance with the anticipated performance model can be cemented by a covenant structure that includes additional obligations related to IP and confidentiality and that restricts both transfers of IP collateral and potential disclosures that could diminish collateral value and loan party performance. Underwriting that reflects the inherent risks of tech companies (such as customer retention, growth rates, customer acquisition costs, and competition), combined with tailored legal diligence and customized credit facility documentation, can provide any recurring revenue transaction with a solid foundation.