In one of our previous blog posts, we referred to the prospect of joint venture partners being required to invest further capital in order to ensure the survival of a business.  In this post, we explore in more detail the issues to be considered before a stakeholder advances additional funds.

Debt or equity

The first question must be whether short-term funding of any kind is likely to make any difference.  If profit forecasts evidence no real prospect of avoiding some form of insolvent liquidation, a cash injection to tide the business over is likely to be a case of throwing good money after bad.  Furthermore, whilst the law on wrongful trading has been relaxed during the Coronavirus crisis, directors should think carefully about continuing to trade when there is a real risk of insolvency, as they could still fall foul of other regulations designed to protect creditors.

The form and commercial terms of any further investment are likely to be dictated by a number of factors, including tax advice and the parties’ precise objectives.  For example, if a cash injection is needed in order to improve the balance sheet position and thereby make the business more attractive to prospective suppliers and third party lenders, an equity investment is likely to be the only option. 

From a legal perspective, debt funding is usually considered preferable from the lender/investor’s perspective where there are ongoing concerns regarding the future performance of the business, as creditors will rank ahead of shareholders on a return of capital.  If, however, an investor believes that the business is likely to become significantly more profitable in the long term if it weathers the current storm, it may wish to participate in the potential “upside” as a condition of making funding available.  This might be achieved through some form of convertible debt, in which some or all of the principal amount of a loan is converted into equity on the satisfaction of certain conditions.

Equity protections

If an equity investment is required in order to bolster the net asset position, the relevant investor(s) should seek to negotiate appropriate protections in the investment documentation, such as:--

• preferential distribution of capital on a winding up;
• veto rights on key decisions;
• guaranteed board representation;
• the ability to take control of management on the occurrence of certain default events;
• the right to receive regular financial information, particularly if the investor is not involved in day to day management;
• pre-emption mechanisms to apply on the issue / transfer of shares; and
• a drag/tag along mechanism to apply on exit.

Debt funding: key terms

The commercial terms of any debt facility (for example, whether interest accrues and at what rate, whether the debt will amortise or become repayable in full on a longstop date, whether minimum earnings or prepayment penalties apply) will again depend on tax considerations, the objectives of the parties and what is practicable.  There is no point in attempting to negotiate a favourable coupon if in reality the borrower will not generate sufficient cash flow to service the payments.

Borrowers often prefer to avoid negotiating a fixed repayment schedule, and instead insert wording which enables them to repay “as and when cash flow allows”. This is unlikely to enforceable without a clear, objective mechanism to determine the level of excess cash flow out of which repayment can be made.  A lender should not accept any such vague wording without at the very least agreeing a fixed ultimate repayment date, and should not expect in all likelihood that it will receive any material repayment before then.

Lenders should insist on various positive and negative covenants, such as a veto over further borrowing or capital expenditure, and a right to receive regular financial information (again, particularly useful if the lender is a passive investor in the business).

It is crucial for any loan agreement to include carefully defined events of default which trigger the ability to demand immediate repayment in full of the loan (and thereby enable the lender to prove for the entirety of the debt on an insolvent liquidation).  Apart from payment defaults and insolvency events, accelerated repayment would also normally be triggered by any other material breach of the finance documents, and a breach of any third party loan agreements, subject perhaps to short “grace periods” which allow the borrower to rectify the default.

Financial covenants

Depending on the level of debt and the willingness of the parties to negotiate detailed terms, a lender would also usually wish to negotiate “financial covenants” which trigger a default if the financial performance of the borrower falls below certain agreed thresholds. Such covenants are usually combined with an obligation on the borrower to provide periodic certificates as to its compliance or otherwise with such covenants.  These give the lender greater visibility regarding the financial health of the business and enable it to take early remedial action if covenant breaches indicate a deterioration in performance.  Common financial covenants include a “debt service” ratio in which the borrower’s EBITDA must exceed a certain multiple of the aggregate interest and principal payments over a certain period.  Any such covenants will require careful drafting in conjunction with detailed forecasts in order to be meaningful.

It is worth considering whether financial covenants should be given on a “look back” or “look forward” basis.  Most covenants tend to test historical performance over a rolling 12-month period, by reference to actual accounts.  In a volatile financial environment, historical figures may be of little use, and lenders may prefer to test against forecast performance; if so, the facility agreement must set out clearly the basis on which any such forecasts are prepared.  For example, in the context of a property rental business, it is common to exclude from the calculations any rent reviews which have not been contractually agreed, and any rental income from tenants who are materially in default.

Security

If practically possible, and particularly if the borrower has valuable fixed assets, lenders would be advised to take security for the debt repayment obligations, either through charges over specifically identified assets, or a “debenture” over all assets of the borrower. 

The availability of security may well be determined to a large extent by the nature and level of any existing debt in the business.  An incumbent secured lender is unlikely to object to the creation of any further security provided the junior debt and security are fully subordinated.  This usually means that the junior lender cannot receive payment of any principal or interest unless the senior lender has been fully repaid, and cannot enforce its security without the consent of the senior lender, whose security will rank in priority on any distribution of assets.

In our experience, incumbent lenders have little incentive to respond promptly to a request to for production of an appropriate intercreditor or subordination agreement, unless further junior funding is crucial to enable full recovery by the senior lender (for example to fund the completion of a property development which will significantly increase the underlying value of the senior security).  If there is an urgent need for cash, junior lenders may therefore be tempted to forego security.  It is possible in such circumstances to put security in place after the event; lenders should be aware, however, that there is a significant risk of such security being challenged by creditors as an unfair preference if funds are advanced without any legally enforceable obligation on the borrower to provide security as a condition precedent or subsequent to the loan.

If security is a feasible option, a lender should consider carefully how to define the liabilities to be secured by the relevant charge.  Borrowers will usually prefer the security to be limited to the specific loan agreement.  If so, further security will need to be granted if additional funding is provided by the lender at a later date; it is usually preferable for the lender to take “all monies” security, which secures funding provided by it on any account.

Conclusion

It is imperative that, in negotiating and documenting the terms of a further cash injection into a struggling business, the parties engage fully with their accountants and legal advisors in order to understand and give effect to their commercial objectives.  At George Green, we are experienced in documenting debt and equity investments, often at short notice, and work with our clients to ensure that the funding is implemented as swiftly as possible while also protecting our clients’ interests.

If you or your business require information regarding debt or equity investment, please call our Banking and Finance Partner, Philip Round, on 07826 906849 or e-mail him at pround@georgegreen.co.uk for advice and assistance.