On ARR financings, lenders accept that the business they are lending to, or funding the acquisition of, will initially generate limited profit or even be loss-making. Without meaningful EBITDA to point to, the group’s performance is instead measured by how much revenue it can produce each year on a reliable, recurring basis.
Such financings are particularly prominent in the tech sector, where subscription-based services provide identifiable recurring revenue, and where there is an acknowledgment that a nascent business incurring significant start-up costs can quickly scale up and become profitable.
What do they look like?
ARR documents are essentially the same as traditional leveraged documents, with the principal difference being that the traditional EBITDA leverage test is, for the first few years at least, replaced with a leverage test based on ARR.
Exactly how the ARR definition is structured will vary from deal to deal, but it is intended to capture reliably recurring revenue, often from subscription fees. If a business derives profit from maintenance, consultancy or service fees, then those will typically be excluded from ARR unless they are paid for on a subscription basis.
ARR may simply look back on a rolling 12-month basis like EBITDA or, instead, be an annualised figure based off the most recent quarter or even the most recent month. An annualised figure based off a shorter period will be more sensitive to underperformance and therefore quicker to highlight issues within a business, but may not make sense for a business with seasonal volatility.
Like its EBITDA-cousin, an ARR leverage test is generally capable of being equity cured, although (to date) lenders have won the argument that the cure amount can only be applied on the debt side of the ratio. There is also a greater likelihood that a percentage of the cure amount will be applied in prepayment of the debt.
Given the increased scrutiny on cash reserves in the early stages of the business’s life-cycle, the lender will also have the benefit of a liquidity covenant – something market participants will have become very familiar with over the past two years, though under altogether less optimistic circumstances. Lenders will want to know not only that a business has sufficient cash reserves to survive any blip in performance, but also that it could shoulder the costs of having to “right-size” its workforce if required.
PIK toggles are a well-known feature of traditional debt fund deals and are very much a staple of ARR financings, given cash can be tight during an initial period of growth. For the same reason, cash sweeps are rarely seen.
The flip side
An ARR loan agreement will provide that the ARR leverage test “flips” to a traditional EBITDA leverage test, generally around two to three years after closing, holding the business to its projection of turning a more substantive profit by that point. Prior to that mandatory adjustment, the borrower may also have a window in which they can elect to make that change. They may be incentivised to do so in order to access the margin ratchet, unlock dividend permissions or enjoy other documentary flexibility, but once a company is generating meaningful profit there may also come a point at which it’s easier for it to meet an EBITDA leverage test, rather than to continually grow revenue at the rate demanded by the ARR covenant.
In most cases, the EBITDA leverage test will be on a gross basis, providing the lender with a purer, more forensic view of performance. The liquidity covenant may disappear at the point of “flipping”, but lenders are sometimes able to negotiate its continued application.
Given the nature of tech businesses, there is likely to be increased scrutiny of the extent to which a group capitalises its research and development costs, and the definition of EBITDA may provide that any capitalised R&D is expressly deducted in order to smooth out the effect any such capitalisation would otherwise have on leverage.
A growing cast of players
Like much in the world of finance, ARR deals began their life in the US, before inevitably making their way across the Atlantic. Whilst the US banks familiar with such financings are also active in Europe, debt funds have spotted opportunities in certain geographies and, of course, in more highly leveraged structures.
The group of debt funds with a track record of European ARR financings is still relatively select, something which that group has used to its advantage in the face of ferocious competition for good credits in the wider, traditional market.
However, the resilience of the tech sector over the course of the COVID pandemic, and the commensurate rise in the number of ARR financings, is continuing to coax a number of other funds in from the sidelines. Any new institutions considering taking the plunge will still need the requisite expertise in the tech sector, but the ARR marketplace may well become a little more crowded in 2022 and beyond.
The Hogan Lovells team have acted on a number of recent ARR financings, including transactions which have involved taking security over source code. Please contact us if you have any queries.
Authored by Francis Booth.