Key Financing Terms Growing Businesses Should Know

In a prior post, we took a closer look at common financing arrangements for growing and bootstrapped businesses. Although we covered a lot of ground, there was limited discussion about the actual terms and provisions that businesses can expect with each type of financing. That’s where we will turn our attention now—a high-level overview of the key financing terms that growing businesses should know.

Because financing arrangements can be structured in an endless number of ways and are subject to negotiation, rather than explaining specific terms and provisions for each type of financing, this post will provide a high-level overview of the most common terms and provisions that are likeliest to find their way into a wide array of funding and debt financing structures.

Obviously, this is not advice of any sort. Legal and tax advice is strongly recommended for anyone trying to better understand these and related terms. The documents and legal and tax consequences of debt and equity financing can be immensely complicated.

With that being said, the below should be a useful introduction to key terms that growing businesses should gain familiarity with. Let’s dive in.

Key (Mostly) Equity Financing Provisions

Conversion Discount

A conversion discount, in the context of equity financing, is a provision that gives investors an advantage when converting their convertible securities (such as convertible notes or preferred stock) into common shares of the company at a later date, typically during a future financing round at a lower price per share than what new investors are paying.

This discount is a benefit for early investors and serves as compensation for the risk they took by investing at an earlier stage when the company’s valuation might have been lower or less certain. It encourages investors to convert their securities into common shares when a priced financing round occurs. Conversion discounts are a common feature of convertible securities and can be a win-win for both early investors and the company seeking funding.

Valuation Cap

A valuation cap plays a pivotal role in convertible securities such as SAFEs and convertible notes. At its core, a valuation cap sets a predetermined upper limit on the valuation of a startup at the time of a future equity financing round. This cap acts as a safeguard for early-stage investors, ensuring that their investments convert into equity at an advantageous price even if the company’s valuation experiences significant growth between the initial investment and the subsequent round.

When a triggering event, like a Series A financing round, occurs, the conversion price for the convertible security is determined based on the terms of that round. However, with a conversion cap, the conversion rate cannot exceed the valuation cap specified in the initial agreement. This means that early investors benefit from a more favorable conversion price compared to the new investors in the round.

Voting and Board Rights

In equity financing, particularly in VC and growth equity deals, voting and board rights provisions are pivotal aspects that shape the dynamics between investors and the company. Common provisions include:

Board Seats: Investors often secure the right to appoint one or more members to the company’s board of directors. These seats grant them direct influence over strategic decisions and corporate governance.
Protective Provisions: Protective provisions, or “veto rights,” empower certain investors to block specific corporate actions. These might include changes to the company’s charter, the issuance of new securities, or major transactions like mergers and acquisitions.
Majority and Supermajority Voting: Certain corporate decisions, such as amending bylaws or approving significant transactions, may be subject to majority or supermajority voting. This ensures that investor interests are considered and can influence crucial matters.

These provisions are meticulously negotiated and tailored to accommodate the unique needs and preferences of both investors and the company. These voting and board rights are instrumental in maintaining a fair and cooperative relationship between investors and the company, while also preserving the company’s ability to operate efficiently.

Although very uncommon with traditional forms of debt, voting and board rights provisions are sometimes used in debt instruments that have both debt and equity components, such as convertible debt and mezzanine debt. This is not to say that traditional lenders cannot exhibit significant influence over the operations of borrowers—protective covenants, which will be discussed later in this article, can be very limiting to borrowers.

Dividend Rights

Dividend rights provisions in equity financing, particularly in VC and growth equity instruments, outline how and when investors are entitled to receive dividends from the company. These provisions often differ from traditional common stock dividends:

Participation Rights: Investors may negotiate for participation rights, allowing them to receive dividends pro-rata alongside common shareholders based on their ownership percentage. This ensures they share in any distributions.
Preferred Dividends: Preferred stockholders, such as those in growth equity deals, might have priority in receiving dividends over common shareholders. Preferred dividends are typically fixed or calculated at a predetermined rate.
Accumulated Dividends: In some cases, preferred stockholders may have accumulated dividend rights, which means that if dividends are not paid in a given period, the unpaid dividends accrue and must eventually be paid before common shareholders receive any distributions.
Dividend Waivers: Equity financing agreements may include provisions allowing the company to waive dividend payments if necessary for business growth or financial stability.

These dividend rights provisions are integral in structuring the financial relationships between investors and the company. They can vary significantly based on the type of equity instrument, investor preferences, and the stage of the company’s development.

Liquidation Preferences

Liquidation preference provisions in startup funding prioritize the order in which investors receive returns in the event of a company sale or liquidation.

Preferred Return: Investors, often holders of preferred stock, negotiate a liquidation preference that ensures they receive their initial investment amount before common shareholders when the company is sold or liquidated.
Multiple of Investment: The liquidation preference may be structured as a multiple of the original investment, guaranteeing investors a set multiple of their initial capital before common shareholders receive any distribution.
Participation Rights: In many cases, preferred stockholders have participation rights, allowing them to receive both their liquidation preference and their pro-rata share of any remaining proceeds.
Liquidation Preference Cap: Liquidation preference caps place a limit on the maximum amount investors can receive in a liquidation event under the liquidation preference, regardless of the multiples negotiated in the preference. However, most preferred securities with liquidation preference caps still provide the investors with the option of converting to common equity, allowing them to fully participate in the distribution if it makes the best financial sense to do so.
Impact on Valuation: Liquidation preferences can significantly impact the valuation of a company, as they affect the potential returns to investors. A high liquidation preference can severely reduce the common shareholders’ share of the proceeds in exit scenarios.

These provisions are essential in structuring the financial relationships between investors and the company, providing a degree of downside protection to investors, and influencing the overall risk-return profile of the investment.

Anti-Dilution Provisions

Anti-dilution provisions in equity financing, commonly found in VC and growth equity instruments, are mechanisms designed to protect the interests of existing investors when the company issues new shares, especially in cases where the new shares are issued at a lower valuation than the previous round. These provisions come in various forms, including full ratchet, weighted average, and pro-rata and preemptive rights:

Full Ratchet: Under a full ratchet anti-dilution provision, if the company issues new shares at a lower price than the previous round, existing investors’ conversion price is retroactively adjusted to the new, lower price. This approach is the most investor-friendly but can be harsh on the company and its founders, potentially leading to significant ownership dilution.
Weighted Average: The weighted average anti-dilution provision is more common and less severe than a full ratchet. It adjusts the conversion price based on a weighted formula that considers both the new and old share prices, as well as the number of shares involved. This method provides a fairer balance between existing investors and the company but still offers protection against substantial dilution.
Pro Rata and Preemptive Rights: These provisions give existing investors the opportunity to maintain their ownership percentage in future financing rounds by allowing them to purchase additional shares before external investors. Pro rata rights ensure that existing investors can invest in proportion to their current ownership, whereas preemptive rights grant them the first opportunity to buy new shares issued by the company.

Anti-dilution provisions play a crucial role in preserving investor confidence and incentivizing continued support. However, depending on the severity of the provisions, this can be a major (and painful) source of founder dilution.

Drag-Along and Tag-Along Rights

Drag-along and tag-along rights provisions in equity financing, especially in VC and growth equity instruments, address situations involving the sale of the company.

Drag-Along Rights: These empower majority shareholders to force minority shareholders to join in the sale of the company. This ensures a unified sale process and facilitates exit opportunities for majority shareholders.
Tag-Along Rights: Conversely, tag-along rights allow minority shareholders to participate in a sale initiated by majority shareholders. This safeguards minority investors’ interests by enabling them to sell their shares on the same terms and conditions as the majority shareholders, ensuring equitable treatment during a sale transaction.

Registration Rights

Registration rights provisions allow investors in unregistered securities (and thus, typically illiquid securities) the right to require the company to register their equity securities with regulatory authorities for public sale.

These provisions ensure that investors have the opportunity to exit their investment by selling their shares on the public market when they choose, subject to certain conditions and registration processes. It provides flexibility and liquidity options for investors in private companies.

Key (Mostly) Debt Covenants

Debt covenants are legally binding agreements or conditions included in debt financing contracts that outline specific financial and operational constraints a borrower must adhere to. Debt covenants serve to protect the interests of lenders by mitigating credit risk and ensuring that the borrower maintains certain financial health and stability throughout the life of the debt.

If covenants are breached, the borrower often goes into technical default. The consequences of a technical default can vary depending on the terms of the loan agreement, the severity of the breach, and the actions taken by both the borrower and the lender.

Although debt covenants can take many forms, it is important to distinguish between two types: restrictive covenants and affirmative covenants.

Restrictive covenants, also known as negative covenants, place restrictions on certain actions by the borrower (e.g., limit dividend payouts). This is opposed to affirmative covenants, also known as positive covenants, which require the borrower to perform certain actions (e.g., perform and share annual audits).

NOTE ON FINANCIAL COVENANTS:

Others often distinguish financial covenants as a third type of covenant. However, for the sake of this discussion, we will be categorizing particular financial covenants as either restrictive or affirmative based on the obligation that is placed on the borrower.

NOTE ON COVENANT DEFAULTS:

A breach of debt covenants in a loan agreement does not always result in a technical default or breach of the loan. Whether a covenant breach constitutes a technical default depends on several factors, including the specific terms of the loan agreement, the severity of the breach, and any remedies or waivers provided for in the agreement. Some things to consider include:

Covenant Severity: The severity of a covenant breach is a crucial factor. Minor breaches may not trigger a default, especially if the lender chooses to waive or overlook them.

Materiality Thresholds: Some loan agreements specify materiality thresholds for covenant breaches. In other words, only breaches that exceed a certain financial or operational threshold will trigger a default. Smaller breaches that fall below these thresholds may not result in a default.

Cure Periods: Loan agreements often include cure periods during which the borrower has the opportunity to remedy the covenant breach. If the borrower rectifies the breach within the specified cure period, it may not be considered a default.

Lender Discretion: The lender’s discretion plays a role. Lenders may have the option to waive covenant breaches or provide amendments to the loan agreement to accommodate the borrower’s financial situation, especially if they believe that the borrower’s overall creditworthiness remains strong.

Cross-Default Provisions: In some cases, a breach of one covenant may trigger a cross-default provision, making all other debt under the borrower’s agreements immediately due and payable. This can result in a technical default on multiple loans instantaneously, even in cases where a single covenant is breached for just one of the loan agreements.

Negotiated Terms: The specific terms of the loan agreement and any negotiated provisions will determine the consequences of a covenant breach. Some agreements may provide for alternative remedies, such as increased interest rates or additional collateral, rather than immediate default.

Restrictive (Negative) Covenants

NOTE ON COVENANT-LITE DEBT:

Although “covenant-lite” debt is often described as debt with limited borrower covenants, especially restrictive covenants, this is not necessarily the case. Covenant-lite is more accurately described as debt instruments with limited maintenance tests. Check out this helpful overview by Practical Law for additional information.

Seniority Ranking and Collateral Priority

Seniority ranking provisions in debt financing are a vital way for lenders to dictate the order of debt repayments in the case of default.

As discussed briefly in the prior post on financing arrangements, seniority ranking establishes the pecking order in which debts are settled during liquidation or financial distress. For instance, a senior term loan may include a provision that specifies that while outstanding, it must remain in the senior position. This means that it will take precedence over other long-term debt instruments, ensuring that the senior debtholder receives priority payment in the case of default (at least in theory).

For borrowers relying on multiple debt instruments, there are often intercreditor agreements that further establish and validate the lenders’ understanding of the repayment waterfall.

Similarly, for loans secured by collateral, similar provisions are often used to specify a lender’s level of repayment priority in the case of liquidation (e.g., first-lien and second-lien).

Debt Limits and Debt Incurrence Covenants

Debt limit provisions in debt financing agreements are designed to regulate and cap the total amount of debt a company can take on.

These limits serve as safeguards against excessive leverage, ensuring that the company doesn’t become overburdened with debt obligations that could jeopardize its financial stability.

Debt limits are instrumental in managing risk, protecting the interests of existing creditors, and maintaining a healthy balance between debt and equity within the company’s financial structure. They are a critical component of responsible financial management in debt financing.

In practice, debt limits are often established using leverage ratios. A common approach taken by lenders is to set a maximum debt-to-EBITDA ratio that cannot be surpassed by the borrower.

Restrictions on Asset Sales (and Fundamental Change Limitations)

Restrictions on asset sales covenants in debt financing are contractual clauses designed to protect lenders by limiting a borrower’s ability to sell significant assets without certain conditions being met. These provisions, and closely related (but broader) fundamental change limitations, are commonly found in loan agreements and bond indentures.

Typically, they require the borrower to seek approval from the lender or bondholders before selling assets of a certain value, ensuring that the borrower’s business (and collateral base) does not become dramatically different than what was originally underwritten.

Dividend Restrictions

Dividend restrictions in debt financing are contractual clauses designed to protect the interests of creditors by limiting a borrower’s ability to distribute dividends to its shareholders. They serve to ensure that the borrower maintains sufficient financial stability to meet its debt obligations before disbursing profits to equity holders.

Dividend restrictions typically set out specific conditions or ratios that must be met for dividends to be paid, such as maintaining a certain level of earnings or a maximum debt-to-equity ratio.

Capital Expenditure Limits

These covenants ensure that a borrower doesn’t undertake excessive capital expenditures that could jeopardize its ability to meet its debt obligations. Capital expenditure limits typically specify a maximum amount or a percentage of revenue that the borrower is allowed to spend on capital projects without seeking prior approval from creditors.

Debt service coverage ratios, such as a fixed charge coverage ratio, is another mechanism that may place limits on borrowers’ capital expenditures. These ratios will be further discussed in the affirmative covenants section below.

Affirmative (Positive) Covenants

Use of Proceeds

Use of proceeds provisions outline how the borrowed funds will be utilized by the company. In debt financing, use of proceeds clauses often specify that the borrowed funds must be used for specific purposes, like working capital or capital expenditures, ensuring that the company utilizes the debt in a manner aligned with its financial needs and obligations.

Use of proceeds can also be a useful way for equity investors to ensure their investments are being used for the intended purpose.

Financial Reporting

Financial reporting provisions in debt financing are contractual requirements that obligate borrowers to provide regular and detailed financial statements to their creditors. These provisions are a crucial component of loan agreements and bond covenants, serving to enhance transparency and accountability. Typically, borrowers are required to submit audited, reviewed, or internal financial reports at specified intervals, such as quarterly or annually, depending on the terms of the agreement.

Banking Requirements

Debt financing agreements will sometimes specify that borrowers must maintain certain accounts with the lending institution. These provisions ensure a closer financial relationship between the borrower and lender, often simplifying transactions and monitoring. These covenants can also enhance lender control while providing additional revenue streams to the lender.

Debt Service Coverage

Debt service coverage covenants are essential components of debt financing agreements. These provisions require borrowers to maintain a specified level of income or cash flow to ensure they can meet their debt repayment obligations. This is typically expressed as a ratio of earnings (e.g., EBIT or EBITDA) to principal and interest payments.

Lenders use these covenants to assess the borrower’s ability to service its debt and reduce the risk of default. If the borrower’s income falls below the specified threshold, it may be in violation of the covenant, leading to potential penalties, higher interest rates, or even default.

Debt service coverage covenants vary in their strictness and can significantly impact a borrower’s financial flexibility. Borrowers must carefully consider these covenants when entering into debt financing agreements, as they can dramatically affect their financial operations and strategic decisions. Conversely, lenders rely on these covenants to protect their investments and ensure borrowers maintain sufficient financial health to meet their obligations.

NOTE ON COMMON COVERAGE RATIOS:

Two commonly used coverage ratios include the debt service coverage ratio (DSCR) and the fixed charge coverage ratio (FCCR). Although the loan documents will lay out the exact calculation of these ratios (these are not fully standardized), they are typically calculated like the below:

DSCR = Annual Net Operating Income / (Cash Interest + Mandatory Debt Repayment)

FCCR = (EBITDA – CapEx – Cash Taxes) / (Cash Interest + Mandatory Debt Repayment)

Collateral Value, Maintenance, and Loan-to-Value Ratios

These provisions specify the collateral that a borrower must pledge to secure the debt and outline requirements to maintain its value. Collateral can include assets like real estate, inventory, or equipment. The covenants establish the minimum value or coverage ratio that the collateral must maintain relative to the outstanding debt.

If the collateral’s value falls below the stipulated threshold, it can trigger default or require the borrower to provide additional collateral. These covenants aim to protect the lender’s interests by ensuring that the collateral remains sufficient to cover the debt in case of default, thereby reducing the lender’s loss severity in the case of default. Borrowers must actively manage and preserve the collateral’s value to avoid breaching these covenants.

Reserves

Reserve requirements in debt financing refer to the practice of setting aside funds in a designated account to ensure the availability of resources for specific purposes, such as debt and interest repayment, taxes, insurance, or capital expenditures. Reserve accounts help mitigate the risk of default by ensuring that funds are available when needed for these obligations.

The amount and terms of reserve requirements can vary and may be linked to specific financial metrics or milestones. Borrowers must adhere to these requirements to maintain compliance with their debt financing agreements, thereby reducing the risk for creditors and enhancing the security of the debt investment.

Reserve accounts are most common for commercial mortgages, especially large construction loans.

Key Terms Related to Interest and Principal Payments

Interest Payments

As may surprise many people who do not have much exposure to debt financing beyond a residential mortgage and a personal credit card, interest can come in many forms. Some key terms are explained below:

Fixed Rate: A fixed interest rate remains constant throughout the entire loan term, providing borrowers with predictable interest payments. This stability makes it easier to budget for loan payments while reducing exposure to interest rate increases but may result in a higher interest rate than the equivalent variable rate when initially secured.

Variable (Floating) Rate: A variable interest rate fluctuates as a benchmark rate (the “base rate” or “reference rate”) moves up and down from period to period. Variable rates are typically priced as a “spread” (also known as the margin) above the base rate. For example, a loan may be priced at SOFR +2.50%, meaning that the interest payment for each payment period is calculated using the then-current SOFR and adding 2.50%.

Prime Rate: The Prime Rate is the interest rate that commercial banks offer to their most creditworthy customers. It serves as a benchmark for many variable-rate loans, including credit cards and home equity lines of credit.
SOFR: Most variable-rate loans today are based on the Secured Overnight Financing Rate (SOFR), a benchmark interest rate that reflects the cost of borrowing in the overnight repurchase agreement (repo) market. It is considered a more transparent and reliable benchmark than the previously used LIBOR (London Interbank Offered Rate).

Teaser Rate: A teaser rate, also known as an introductory or promotional rate, is a temporarily lower interest rate offered at the beginning of a loan to attract borrowers. After a set period, the rate typically increases to the standard variable rate.

Effective Interest Rate: The effective interest rate represents the true cost of borrowing because it includes not just the nominal interest rate but also any fees, points, or other costs associated with the loan. It gives borrowers a more accurate picture of their borrowing costs.

Default Interest Rate: When a borrower enters default due to missed payments or a breach of debt covenants, the lender may impose a higher interest rate called the default interest rate. Like other interest, this rate is applied to the outstanding balance and serves as a penalty for late or missed payments.

Interest-Only: An interest-only loan allows borrowers to make payments that cover only the interest portion of the loan for a specified period, usually at the beginning of the loan term. This reduces initial monthly payments but will lead to a larger principal balance owed later. Project financing instruments will often include an interest-only period, as will some high-yield debt offerings.

Paid-In-Kind (PIK): PIK interest allows borrowers to pay interest on a loan by adding it to the principal balance rather than making cash interest payments. This can be advantageous for borrowers with cash flow constraints, but it can also result in a growing debt balance over time. PIK loans are often used in certain corporate finance and high-yield debt.

Principal Payments

Term: The term of a loan refers to the period during which the borrower is required to make regular payments or repay the loan in full. It can vary widely, with short-term loans typically lasting a few months to a year, and long-term loans extending for several years or even decades. The term often influences the interest rate and the total cost of borrowing.

Payment Frequency: Payment frequency indicates how often borrowers are required to make payments on a loan. Common payment frequencies include monthly, quarterly, semi-annually, and annually (monthly for many small business loans, and more commonly quarterly or semi-annually for larger corporate debt securities).

Amortization: Amortization refers to the process of paying off the principal over the term of the loan through regular payments or pre-scheduled lump payments. Each payment typically consists of both principal (the loan amount) and interest. For a fixed payment amortizing loan, early in the loan term, a higher portion of the payment goes toward interest, while later in the term, more goes toward reducing the outstanding principal balance.

A fully amortizing loan is one where the entire principal balance is paid in periodic payments throughout the loan balance.
In the case of interest-only payments, the entire principal amount will be due at the end of the loan term (there is no amortization), a lump payment that is often referred to as a balloon payment.
Other loans may be partially amortizing, meaning some of the principal is paid throughout the term, but there remains a portion of the principal balance to be paid at the end of the loan term with a balloon payment.

Mandatory Paydowns and Pro Rata Sharing Clauses: Mandatory paydowns are provisions in loan agreements that require borrowers to make additional principal payments beyond their regular payments at specified intervals or under certain conditions. Pro rata sharing clauses are terms that govern how these extra payments are distributed among lenders in a syndicated loan, ensuring that all lenders receive their fair share.

Prepayments: Prepayments allow borrowers to pay off a portion or the entire loan balance before the scheduled maturity date. Some loans may have prepayment penalties or fees, while others are open to prepayments without additional costs. Prepaying a loan can help borrowers save on interest and reduce their overall debt burden. Prepayments will be discussed further below in the Call Provision section.

Revolving Credit: Revolving credit is a type of debt agreement that provides borrowers with a maximum credit limit from which they can borrow, repay, and borrow again without the need for a new loan application. A revolving line of credit acts somewhat similar to a major credit card for a business. Within revolving credit agreements, there are several key terms, including:

Draw Period: During the draw period, borrowers can access funds up to the credit limit and make minimum payments or pay off the balance. Interest is typically charged on the outstanding balance.
Non-Utilization/Commitment Fee: This is a periodic charge applied by the lender for the portion of the credit line that remains available but unused by the borrower.
Repayment Period: After the draw period, the repayment period begins. Borrowers are no longer able to draw additional funds, and they must start repaying the outstanding balance. Payments may include both principal and interest.
Irrevocable vs. Revocable: Irrevocable refers to a credit commitment that cannot be canceled by the lender, providing more certainty to the borrower. Revocable credit commitments can be withdrawn or canceled by the lender, often with notice, providing less certainty to the borrower.

Bond Sinking Funds: A bond provision that requires the borrower to pay some of the principal at certain years is commonly referred to as a “sinking fund provision” or simply a “sinking fund.” A sinking fund is a requirement in a bond indenture or loan agreement that obligates the issuer or borrower to set aside a portion of the bond’s face value (principal) at specific intervals or on predetermined dates. These set-aside funds are then used to retire a portion of the outstanding bonds, reducing the total debt over time.

Call Provision: A call provision, commonly found in a bond indenture, is a contractual agreement that gives the issuer of the bond (the borrower) the option, or “call right,” to redeem the bond before its scheduled maturity date (i.e., a prepayment). When a call provision is exercised, the issuer buys back the bond from bondholders at a predetermined price, often at a slight premium to the bond’s face value.

Call protection is the call provision’s counterpart that places restrictions (e.g., make-whole call provision, yield maintenance) on the borrower’s ability to prepay the debt.

From the borrower’s perspective, having the option to redeem the debt early is especially valuable in instances where the borrower’s cost of borrowing (i.e., interest rate) is expected to fall in the immediate or intermediate term. In such scenarios, the borrower can replace a more expensive capital source with a cheaper one.

Put Provision: A put provision, often included in a bond indenture, is a contractual feature that grants bondholders the right, but not the obligation, to sell the bonds back to the issuer or a designated party before the bond’s scheduled maturity date. This option is exercised at the discretion of the bondholder, and when invoked, it allows the bondholders to demand repayment of the bond’s face value, plus any accrued interest, at a specified put price.

From the borrower’s perspective, although its inclusion may help negotiate better terms elsewhere in the agreements, put provisions are especially undesirable in instances where the interest rates are expected to increase. In such scenarios, the debtholder(s) may seek to replace the debt with a higher-yielding new issuance, many times requiring the borrower to refinance at a higher interest rate.

Other Common Provisions

Guarantees

In the context of debt financing, a guarantee is a legally binding commitment made by a third party, often referred to as a “guarantor,” to assume responsibility for the repayment of a debt obligation if the primary borrower, typically the issuer of the debt, fails to meet its payment obligations. Guarantees enhance the creditworthiness of the borrower in the eyes of lenders or investors, as they provide an additional layer of security.

Guarantees can take various forms, including personal guarantees by individuals, corporate guarantees by affiliated entities, or specific asset pledges. They are commonly used in lending scenarios, such as loans to businesses, where lenders seek reassurance that the debt will be repaid even if the primary borrower encounters financial difficulties.

Although guarantees play a crucial role in mitigating credit risk for lenders, they at times require guarantors to assume sizable risk, as they are legally obligated to cover the debt payments if the primary borrower defaults. For businesses with strong credit, personal guarantees are less common.

Debt-Equity Conversion

Debt-equity conversion, a critical aspect of debt financing, is a financial arrangement that allows lenders, typically creditors or investors, to convert their outstanding debt holdings into ownership equity in the borrowing company.

Warrants (often called an “equity sweetener”) are closely associated with debt-equity conversion and are common in venture debt and high-yield debt instruments. These financial instruments grant the holder the right, but not the obligation, to purchase a specified number of the company’s common shares at a predetermined price, known as the exercise price. In the context of debt financing, warrants are frequently attached to the debt securities, giving the lender the opportunity to transform their debt investment into an equity stake when they choose to exercise the warrant.

The exercise price is a key element of this arrangement, as it sets a fixed price at which the warrant holder can convert their debt into equity or acquire company shares. Exercise prices are negotiable but are often set at or slightly above the equity value at the time of issuance.

Ultimately, debt-equity conversion as well as equity sweeteners such as warrants, serves the interests of both lenders and borrowing companies. Lenders have the potential to participate in the company’s growth and profitability by converting their debt into equity, benefiting from future appreciation in the stock price. On the other hand, borrowers gain access to financing with potentially more favorable terms and increased flexibility in managing their capital structure.

Conclusion

Although a lot of financing terms and provisions have been covered above, this has only been a rudimentary overview of what may show up in equity purchase agreements, loan documents, and bond indentures. Although not the case for smaller business financing arrangements, relatively complex business financing instruments often rely on multiple handfuls of interconnected agreements with hundreds of pages of legal language required by the lender or the borrower’s counsel.

With this in mind, it is often best for leaders of growing businesses to fully understand the basic and most important terms in financing arrangements while relying on trustworthy and experienced counsel and advisors to assist in risk management and the protection of shareholder interests.