Recurring Revenue Loan: a Worked Example

A software business that sells subscriptions spends heavily to win each customer and earns the money back over years. While it is growing it can show little or no EBITDA, which makes a leverage covenant of debt to EBITDA meaningless: any loan divided by nearly nothing is a very large number. Its strength is elsewhere. Customers who sign up tend to stay, the revenue arrives monthly or annually under contract, and the cost of serving one more customer is small. A lender willing to rely on that renews its comfort each quarter from the revenue rather than the profit.

The product was developed mainly in US private credit, often for software businesses owned by private equity funds. This page does not describe how widely it is offered in New Zealand, Australia or the UK; it explains the mechanism wherever a lender uses it.

The definition of ARR does most of the work, and the agreement writes it, not the borrower's investor presentation. Agreements commonly exclude one-off fees, hardware, implementation and professional services, revenue from customers in arrears beyond a set period, and free trials. Many add a minimum liquidity covenant for the revenue-based period, because the business is spending cash. Interest is often partly paid in kind, which keeps cash in the business and adds to the debt.

The flip is the date, or the condition, at which the covenants convert to EBITDA terms: often a fixed point a few years after signing, with an option for the borrower to flip earlier if it can already meet the EBITDA test. Some agreements also change pricing or loosen restrictions once the loan has flipped.

A fleet-telematics software business, constructed for this page like every figure in it, sells tracking subscriptions to trucking firms. Monthly recurring revenue is US$2.0m, so ARR is US$24.0m; it also earns US$6.0m a year from selling and installing the tracking units, which the agreement excludes from ARR. It borrows US$30.0m, 1.25 times ARR, at 10% interest of which 3% is paid in kind, compounded yearly here for simplicity. The covenants are total debt to ARR of no more than 1.6 times and liquidity of at least US$4.0m, with a flip to net debt to EBITDA of no more than 6.0 times at the end of year 3. These levels are the example's, not a market norm.

The weaker year barely troubles the revenue covenant: ARR would have to fall another US$3.8m before 1.6 times is breached. The weakness shows elsewhere. Net retention under 100% means the existing customers are shrinking, and new sales are only just replacing them. Its net debt would also be higher, because a weaker business burns more cash. On that path the business cannot reach the EBITDA the flip requires without deep cuts to the sales spending that produced its growth. The lender's real test was set for year 3 on the day the loan was signed.

A cash-flow loan is sized on EBITDA and tested on leverage and cover from the start: the borrower already earns enough to service the debt. A recurring revenue loan lends ahead of those earnings and converts to a cash-flow loan at the flip. Venture debt, the other loan offered to loss-making technology businesses, is usually smaller, relies more on the next equity round and often carries warrants. And an asset-based facility lends against receivables or stock that could be sold; a subscription contract has value only while the customer keeps using the software.

DEFINED IN ONE PARAGRAPH → · BANK LOAN VS PRIVATE CREDIT → · PIK INTEREST →

A lender reading a recurring revenue loan reads four things. The definition of ARR, line by line, because the borrower's own figure is often wider. The retention record by customer group, because a strong total can hide one large customer leaving. The cost structure, because the flip assumes sales and marketing can be reduced without the revenue falling with it. And liquidity, because a business can pass its revenue covenant while running out of cash. In a downside, the lender's recovery depends on the software and its customer contracts being saleable to another owner, which is why it also reads who owns the code and how freely the contracts can be transferred.

LIQUIDITY COVENANT → · LOAN COVENANTS, EXPLAINED →