Financing partners often want to secure their positions in contracts by using control terms that give them greater leverage in obtaining repayment on the underlying contract debts and ensure they have a security interest in the debt. Most financing partners will prepare their own contracts for the debtor to sign. As the United States Small Business Administration (SBA) explains, investors who provide venture capital to a startup or struggling business typically want some degree of control over the direction the company will take in exchange for the financial risk they are assuming. Financing in exchange for equity rather than in expectation of repayment with interest gives venture capital investors a stake in the company’s future success, but can also limit a founder’s ability to make decisions independently. Understanding common control terms sought by financing partners can help you know what you are agreeing to ahead of time and ensure your rights are protected throughout the lifetime of the agreement. Consider consulting with an experienced business lawyer at Harrison Law, PLLC by calling (480) 320-2310.
Duty To Act in the Ordinary Course of Business
Financing partners often include a provision that states the business debtor must act within the ordinary course of business. This provision preemptively restricts the debtor from taking certain actions that may be detrimental to the financing partner’s interests.
Financing partners understand that the business must continue to operate efficiently for the debt to be repaid. Investors providing venture capital usually do not want to be responsible for taking over the business. At the same time, they want to ensure that the business owner will not take action that can leave the financing partner’s security interest vulnerable.
Defining Business As Usual
The ordinary course of business involves anything that is routine for the business. A historical analysis of the business’ previous actions may be necessary to establish what is and is not part of the ordinary course of business. However, some common examples of actions that would fall outside the ordinary course of business unless shown otherwise might include:
- Selling business assets that are necessary to the continuance of business operations
- Granting a lien on business assets
- Selling excess inventory
Significance of Provision
This type of provision is important because it can limit the actions the debtor might take that could adversely affect the financing partner’s security interest and ability to enforce a judgment they may receive against the debtor. However, the term “ordinary course of business” is rather subjective. Therefore, it is important for financing partners to create clear language establishing parameters for whether an act falls within the ordinary course of business, as well as criteria for determining when a business decision strays outside these lines. An experienced lawyer with Harrison Law, PLLC can advise you on how to draft such provisions and can help create agreements that provide clear control terms sought by financing partners such as the ordinary course of business provision.
Restricted Activities
Many financing agreements contain restrictive covenants that prohibit the borrower from taking actions that could adversely affect the financing partner’s interest. Common restrictive covenants in investment term sheets include the following:
- Limiting the right of the business to take on additional debt
- Preventing the business from further encumbering assets or providing a security interest in the collateral that is subject to the financing agreement
- Changing the name, business location, or type of business during the course of the loan
- Changing ownership of the business or merging with another business
- Making legal arrangements with affiliates
- Taking other money from investors or creditors during the life of the loan
- Selling material assets of the business
- Amending any existing agreements to do any of the activities described above
- Taking any action that would be contrary to the interests of the business or financing partner
These restrictive covenants can have a significant impact on a business. Therefore, it is essential to understand what you are agreeing to before signing any such agreement. An experienced business law attorney can review any agreement you are contemplating entering into and explain the relevant terms and how they may impact you.
Covenants
Just as a financing partner may restrict the borrower from taking certain actions, it may also require the borrower to take others. In this way, financing agreements can establish parameters for how the business should be operated, identify issues related to repayment or possible default as they arise, and ensure the borrower can repay the debt. Common covenants included in commercial financing agreements include:
- Using the financed funds as intended when seeking credit and approval
- Maintaining business insurance
- Making consistent on-time payments
- Maintaining all tax payments
- Keeping detailed financial records and providing them to the lender upon request
These affirmative duties are just as important to understand as are the restricted activities prohibited by an investment contract.
Default Provisions
An investor providing venture capital in exchange for equity will see a return on investment, or not, as the fortunes of the company itself rise or fall. When the capital is secured in the form of a loan, however, the signed agreement will likely include control terms for what should happen in case of default on the loan. Neither party will wish for this outcome, but if default does occur, the lending entity will want to ensure that they have solid provisions in place to protect their interests. Default provisions may identify what constitutes default and the penalties that will be imposed upon the debtor, such as having to pay extra fees, legal costs to enforce the agreement, or other monetary penalties. Many investment term sheets also include an acceleration clause that allows creditors to require all remaining payments immediately.
Governing Law and Jurisdiction
Because laws vary by each state, the drafter of the contract will often choose which state’s law will apply to the interpretation of the contract. Additionally, the contract may state where any disputes involving the agreement will be heard.
Deposit Control Agreement
Some financing agreements will include an additional deposit control agreement that sets out terms for how the funds are to be used. This deposit control agreement is binding upon the debtor, creditor, and the bank where the funds are held. The Arizona Revised Statutes allows the creation of this type of agreement, which allows the debtor to use the account without providing further consent while still protecting the lender’s security interest in the funds.
Contact a Knowledgeable Business Law Attorney for Assistance
Financing is essential for many businesses to effectively operate. However, financing agreements are often complex documents, and both investors and business owners may benefit from a careful review of common control terms sought by financing partners. Learning about the implications of these terms and how they impact your rights as a financing partner or as the owner of a company can help you make informed decisions about whether it is in your best interest to enter into a particular agreement. If you would like to learn more about your rights in a specific contract, schedule a private consultation with a knowledgeable business law attorney at Harrison Law, PLLC by calling (480) 320-2310 today.
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This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.
