When Tech Deals Go Wrong: Why Covenant Analysis Matters More Than Ever in Software Credits

Liability management exercises are no longer the exception. They are a standard part of the sponsor toolkit, and the documentation written just a few years ago is now allowing sponsors and their lawyers to restructure thebalance sheet within the four corners of a credit agreement. In tech and software, that risk is more dire than in any other sector, because the value that moves is the entire value of the business.

When I started in leveraged finance more than twenty years ago, liability management was not the market-moving trend that it is today. Now deals are being structured with LME flexibility built in from day one. Restructuring teams sit down the hall from finance teams at the major law firms, and every covenant package reflects what the last LME taught them.

Software as a sector exacerbates this trend. You cannot movea factory overnight, but you can license a code base to a new entity in a matter of days. That is a critical distinction. By the time lenders react, the value has already left the credit group.

The Xerox transaction is a warning of things to come. The company moved its core IP into an entity outside the credit group and raised new debt against it, reallocating more than one hundred million dollars of cashflow away from existing holders. Octus described how the company circumvented its J.Crew Blocker by using a joint venture structure rather than the tried-and-true Unrestricted Subsidiary route. If this is possible with hardware patents, it is cleaner and faster with software code.

Newfold Digital tells a different story about LMEs. An amend-and-extend brought in fresh money and pushed maturities out, but the underlying business kept losing subscribers. An LME only works if the business stabilizes. Otherwise it postpones a crisis rather than solving one.

Enforcement in tech is its own problem. The going concern value can dwarf liquidation value because the value sits in people, customers ,and IP rights rather than hard assets. Servers are leased, offices are rented, and the best engineers are the first ones out the door when signs of stress emerge.

The issues diverge, but the lesson is consistent across both situations. The agreements made by lenders before signing matter more than the remedies available after default.

Some quick tips:

• Read the docs, not the pitch.
• Sort the borrower’s assets into three buckets: your collateral, someone else’s collateral, and unencumbered.
• Look at blockers and amendment thresholds before you look at debt and liens capacity.

The flexibility is in the agreement already. The only question is whether anyone noticed.

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