In loan agreements, lenders customarily require the borrower to make various financial covenants whereby the borrower promises to achieve certain financial metrics, often requiring the borrower to stay above or below certain thresholds based on its operations. Since financial covenants are based on past financial performance, breaches of financial covenants typically cannot be cured in the absence of some sort of cure provision. This is why the concept of an equity cure provision is an attractive option for borrowers. An equity cure provision allows a borrower’s shareholders to inject additional equity into the borrower in order to cure an existing breach of a financial covenant, so that the breach does not trigger an event of default. The issuance of additional equity creates a cash infusion enabling the borrower to increase its cash flow or EBITDA or reduce debt to meet the relevant financial covenants, such as a leverage ratio, operating cash flow ratio, or debt service coverage ratio. Essentially, an equity cure provision allows the borrower to go back in time to improve its financial metrics so that it is deemed to have been in compliance with the applicable covenant as of the measurement date. More and more, borrowers or their financial sponsors will request and lenders, in some cases, agree to the inclusion of an equity cure provision in the credit agreement. The borrower’s ability to utilize an equity cure to stave off a potential default is not unlimited, however. Typically, lenders will impose certain limitations on a borrower’s ability to use these provisions. When negotiating equity cure provisions, borrowers and lenders must consider a variety of factors to best serve their interests.
Frequency of Equity Cures
For borrowers, one of the most important aspects of an equity cure provision is how often the borrower can use the equity cure. Lenders prefer to limit the number of cures allowed throughout the term of the agreement and will often restrict the number of uses of the cure in consecutive periods. For example, a lender may limit a borrower’s exercise of an equity cure provision to no more than twice in one year and no more than three times over the term of the agreement. Such limitations enable the lender to prevent a scenario where the borrower could potentially use the equity cure as a cover-up for its continuing financial struggles. When negotiating an equity cure provision, borrowers should push to minimize the restrictions on their ability to use the cure, which will decrease the likelihood of defaulting on a financial covenant. Continue Reading