What Every Company Should Know Before They Sign on the Dotted Line
In this piece, growth debt advisory firm Spinta Capital discusses with Orrick, Herrington & Sutcliffe partner Dolph Hellman the topic of default provisions related to venture debt and growth capital debt.
Spinta Capital: Dolph, thanks for chatting with us about the topic at hand – Default Provisions. Across the 15 or so debt financings we’ve closed in the past year, we’ve seen wide-ranging levels of “default angst” from our entrepreneur and management team clients. We’re hoping that you can share some commercial clarity and best practices around this topic.
Before we dive in, tell us a bit about your practice and why you enjoy serving as a debt lawyer to emerging companies.
Dolph Hellman: I hate to date myself, but I’ve been advising clients in connection with venture debt and growth capital debt transactions since the late 1990s (does the name “Comdisco” sound familiar?). During that entire time, I’ve been fortunate enough to have practiced at Orrick, which has one of the best – if not the best – emerging company practices in the U.S. (and, dare I say, the world, given Orrick’s global footprint). During that time, I’ve advised hundreds (if not thousands) of clients on venture debt and growth capital debt transactions from as small as $1 million to as large as $50 million.
What I really enjoy about representing emerging companies in these types of transactions is that I often get to work directly with the CEO and CFO founders on a financing that may very much be transformational to their companies. The amounts my clients raise in connection with these transactions facilitate them to expand their business, hire new employees, focus more on R&D, etc., and most importantly extend their company’s “runway,” enabling them to put off additional equity raises until a later date, thus minimizing ownership dilution. I really feel I add value to these clients and, for the most part, my clients very much appreciate that.
Spinta: When do you recommend a company engage counsel during the debt raise?
Dolph: Definitely prior to signing a term sheet. That may sound self-serving, but in actuality it’s the opposite. The most important time during any venture debt and growth capital debt transaction is the term sheet stage, as this is when the borrowers have the most leverage. I can honestly say that engaging me or another venture debt expert to spend a half hour of his or her time reviewing a term sheet will be money well spent; since inevitably we will identify terms that may be improved upon, ambiguities that may be clarified, and items that are missing that should be stated (for example whether or not the form of Loan and Security Agreement will contain any “subjective” events of default).
Spinta: Interesting … are there some common provisions that companies and lenders should be hashing out at the term sheet stage but frequently don’t?
Dolph: Absolutely! Term sheet negotiations involving just the business folks tend to be centered on the key economic building blocks of the loan. However, there can be important legal points that are overlooked. For example, term sheets may not contain much detail around various governance provisions, and contain blanket phrases like “usual and customary” for provisions such as affirmative and negative covenants, performance or financial covenants, events of default, or mandatory prepayments. We find it’s helpful to flesh out more detail around these terms at the term sheet stage when both parties are motivated to find common ground, or at a minimum ensure the lender and the company have a detailed discussion around what “usual and customary” typically means.
Spinta: Great segue into our key theme – default provisions. Our clients have a tendency to be concerned about defaults of all types. But … perhaps you can decode the different flavors of default cases and how they are viewed by lenders.
Dolph: Broadly speaking, there are four types: Technical, Monetary, Change in Status and Subjective. By way of background, a Technical Default is when a borrower violates an affirmative covenant (typically after some limited cure or grace period) or negative covenant (typically with no grace period). For example, the borrower fails to provide certain financial information by its due date, or fails to comply with a financial covenant. These defaults are by far the most frequent (and typically least troublesome) type of default case. Monetary Default is literally a missed principal or interest payment and is usually indicative of a more serious problem with the borrower’s credit quality or liquidity. A Monetary Default usually places a borrower into a high risk category within a lenders’ risk rating spectrum (e.g. into a “workout group” at the lender). Change in Status Defaults – like a judgment against the borrower above a certain threshold or a default in connection with another debt obligation – may also put the borrower into a high risk category within a lender’s risk rating spectrum. And, needless to say, becoming insolvent or filing for bankruptcy means that the borrower is in dire straits. Finally, Subjective Defaults such as “material adverse change” and “investor abandonment” are less dire than Monetary Defaults and insolvency/bankruptcy but much more dire than Technical Defaults since it’s a subjective determination made by the lender based on the occurrence of an event (e.g. that the financial condition of the borrower has deteriorated such that the prospect of repayment of the loan has diminished). Given the fact that whether a Subjective Default has occurred is in the “eye of the lender,” it’s important for borrowers to focus on the exact wording to make sure they are comfortable with giving their lender that type of default trigger.
Spinta: In your experience, what are the key default triggers and, of those, what are most commonly tripped by venture stage companies?
Dolph: As mentioned above, key triggers of Technical Defaults we see in the venture debt landscape include violations of affirmative covenants such as inadvertently failing to be in good standing in a particular jurisdiction where the borrower does business, failing to deliver financial reports by the due date, and negative covenants such as permitting a change in management to occur without the lender’s prior consent, violating a prohibition on incurring additional indebtedness or allowing additional liens on the borrower’s assets, or repurchasing stock from former employees in an amount in excess of what’s otherwise permitted. Again, not necessarily a huge deal – after all, it doesn’t necessarily mean that the borrower will not be able to repay the loan when due – but best to be avoided nonetheless.
Spinta: In our experience, Technical Defaults are not at all uncommon in venture land. Since you remain actively involved throughout amendments and workouts, how have you seen lenders utilize these provisions? In other words, what is the range of possible outcomes and most common resolutions in a Technical Default scenario?
Dolph: In my experience, as long as they’re remedied promptly most lenders view these Technical Defaults as something that’s not too material. As such, they will often proactively suggest that the parties enter into an amendment or waiver to address the issue (and to avoid a cross default into another debt agreement). On rare occasions, a lender will use this as an opportunity to extract their “pound of flesh” from the borrower in the form of an amendment or waiver fee (or on even rarer occasions use this as an opportunity to exit the credit by requiring the borrower to find replacement financing – typically when that lender is exiting the venture debt market). However, in my experience, that is very unusual since the lender knows that it will likely want to make loans to other companies supported by the VCs that are VCs of their current borrower and they don’t want to earn a reputation among the VC community as being a difficult lender to work with when one of their portfolio companies hits a bump in the road.
Spinta: We recently had a CFO tell us he was OK with tighter covenants because it helped keep his CEO disciplined. Perhaps an anomaly. But are there cases where a company might benefit from tighter financial covenants? Any truth to this?
Dolph: An interesting question, but yes, lenders may have an easier time helping a company through a default scenario if they have an earlier warning that the business is underperforming. If that same warning comes later, the company’s remedy options or timing window might be more limited, causing the lender to act more swiftly and abruptly, perhaps not always in the best interest of the borrower. That said, from my perspective, there may be other ways to discipline a CEO, and since it’s always better not to be in default, my advice is generally to build as much headroom into the financial covenants and negative covenants as possible.
Spinta: What about subjective default clauses like Material Adverse Change or Investor Abandonment, and perhaps others? Who uses these and how are they typically used?
Dolph: In my experience, most venture debt lenders insist on at least one Subjective Default in their transactions (I can think of only one lender that doesn’t). As mentioned above, these provisions should be confirmed at the term sheet stage. The two main Subjective Defaults are (i) material adverse change and (ii) investor abandonment. Material adverse change is typically defined as “(a) a material impairment in the perfection or priority of lender’s lien in the collateral or in the value of such collateral; (b) a material adverse change in the business, operations, or financial condition of borrower; or (c) a material impairment in borrower which adversely impacts the ability of Borrower to repay any portion of the obligations owed to lender when due.” Investor abandonment is typically defined as when “lender determines in its good faith judgment that it is the clear intention of borrower’s investors to not continue to fund borrower in the amounts and timeframe to the extent necessary to enable borrower to satisfy the obligations owed to the lender as they become due and payable.” Of these two, I prefer investor abandonment since it’s less subjective and entirely within the control of the borrower’s investors. I also think it’s a fairer test since many emerging companies will have adverse changes in their businesses from time to time, which in theory would allow a lender to accelerate its loan at that time, but it may not in fact be a true indication as to whether or not the borrower will be unable to repay the loan when due.
All that said, it’s extremely rare that a lender will rely on a Subjective Default – and in particular a material adverse change default – as the basis for declaring a loan due and payable. This is because if they are wrong they will have opened themselves to a claim of lender liability, which no lender wants. Instead, most lenders will use a Subjective Default as a hammer to threaten to use to compel a borrower to agree to some sort of workout or restructuring.
Spinta: How many times might a company expect to “default” during the life of a loan?
Dolph: A borrower should never expect to default during the life of a loan, but as they say, “things happen” (or something along those lines). When a default does occur, the most important thing the borrower needs to do is let its lender know as soon as possible. Not only does that build up good will between that borrower and its lender, but it also provides the lender with more time to react and propose a solution. In my experience, nothing infuriates an account officer more than finding out about a default way past the date the borrower first knew about it.
Spinta: How might a borrower mitigate risk of default at the term sheet stage?
Dolph: Prudent establishment of appropriate covenants with appropriate cushions and reasonable cure periods/remedies can help this significantly. All venture debt lenders realize that most likely there will be ups and downs for their emerging company borrowers, so in my experience they are willing to work with their borrowers to make sure that reasonable cushions and cure periods are built into the covenants. After all, as discussed above, neither the lender nor the borrower want to see a loan go into default.
Spinta: How does the fiduciary role of a company’s Board change (or not change) in a default scenario? How about for a company approaching “insolvency”?
Dolph: That’s a complex question and one best answered by members of Orrick’s insolvency law/bankruptcy law group, but in sum once a borrower enters the “zone of insolvency,” board members have a fiduciary duty to look out for the best interests of the borrower’s creditors as opposed to just the borrower’s shareholders.
Spinta: We’ve heard the catchphrase “turn the keys over to the lender” a bunch. We view that outcome as atypical, but what have you seen, and what might have transpired to get to that stage?
Dolph: That’s a laymen’s term for what’s referred to in the Uniform Commercial Code as a “strict foreclosure” or “consensual foreclosure.” I can count on one hand how often I’ve seen it during my 28 years practicing law, so it’s not that common. This is primarily because lenders are not in a very good position to dispose of the assets they have foreclosed upon for the best possible price since (i) they don’t know who the likely buyers will be and (ii) absent a formal appraisal, they most likely will not know the true value of the foreclosed-upon assets. From a lender’s perspective, they would prefer to have management or the board handle the sale and turn the proceeds over to them – particularly when it comes to intellectual property. That’s why some lenders build into their loan documents a pre-set forbearance/cooling off period to allow those in the know (e.g. management and/or board members) to be in charge of this process.
Spinta: Can/do you (Orrick) play a role in default resolution, as counsel to lenders and/or borrowers? If so, what types of resolutions are you most frequently engaged on?
Dolph: It really depends on the situation and the parties involved, but yes, we will represent companies in connection with both pre-bankruptcy filing and post-bankruptcy filing workouts. We also represent lenders (in each case, assuming no ethical conflict).
Spinta: Thanks so much, Dolph. Great speaking with you – this serves as quite a helpful primer on defaults.
Dolph: My pleasure.
About Spinta Capital
Spinta Capital is dedicated to helping mid and later stage emerging growth companies efficiently arrange growth and venture debt for business expansion. With a goal of optimizing capital cost and flexibility, we assist management in navigating the credit markets with speed and intelligence. Founders, CEOs, CFOs and equity investors use our services to save time, eliminate guesswork, and achieve great financing outcomes.
About Orrick Herrington & Sutcliffe
Orrick is a leading global law firm with a particular focus on serving clients in the technology, energy and financial sectors. Founded in San Francisco a century and a half ago, Orrick today is named by Law360 as one of the “Global 20” leading firms. With approximately 1,200 lawyers across the United States, Europe and Asia, our platform offers clients a distinctive combination of local insight and consistent global quality across our key market locations. Our Venture Capital team is ranked #3 as the “Most Active VC Law Firm” Globally, and #1 “Most Active VC Law Firm” in Europe according to PitchBook. We represent innovative companies and investors at all stages, including: 1,800 high-growth tech companies globally, 20 percent of $1bn U.S. unicorns, 10 of the world’s 25 biggest tech companies, and 33 percent of the most active early-stage VCs.