Borrowing base deficiency: Overview, definition, and example
What is borrowing base deficiency?
A borrowing base deficiency occurs when the value of the assets that a business has pledged as collateral for a loan falls below the required minimum value needed to secure the loan. In a lending arrangement, a lender may provide funds to a business based on a percentage of its eligible assets, such as accounts receivable, inventory, or other assets. The "borrowing base" is the maximum amount a business can borrow, and a deficiency arises when the value of these assets drops, leaving the business with less available credit than originally agreed upon.
In simpler terms, borrowing base deficiency means that the business’s collateral is worth less than what is needed to support the loan, creating a shortfall in available borrowing capacity.
Why is borrowing base deficiency important?
A borrowing base deficiency is important because it signals potential financial trouble for the borrower. When a deficiency occurs, the lender may require the business to provide additional collateral, reduce the loan balance, or even trigger default provisions in the loan agreement. This can result in the business having limited access to credit or facing higher borrowing costs.
For SMB owners, understanding borrowing base deficiency is crucial for managing debt, ensuring adequate collateral is in place, and avoiding situations where borrowing capacity is reduced or loans become due unexpectedly.
Understanding borrowing base deficiency through an example
Let’s say a company has a line of credit secured by its accounts receivable and inventory. The lender has agreed to a borrowing base of $500,000, meaning the company can borrow up to this amount based on the value of these assets. However, the company’s accounts receivable and inventory have decreased in value due to a slow-down in sales and unsold inventory. As a result, the value of the eligible assets is now only $400,000.
In this case, the company faces a borrowing base deficiency of $100,000 ($500,000 borrowing base minus the $400,000 in collateral value). As a result, the company’s access to credit is reduced, and they may need to provide additional collateral or make other adjustments to meet the lender’s requirements.
Example of a borrowing base deficiency clause
Here’s how a borrowing base deficiency clause might look in a loan agreement:
“In the event that the Borrower’s Borrowing Base, as determined by the Lender, is insufficient to support the outstanding loan balance, the Borrower agrees to either (i) provide additional collateral to restore the Borrowing Base to the required level, or (ii) repay a portion of the outstanding loan to eliminate the deficiency. If the Borrower fails to cure the deficiency within [insert time period], the Lender may exercise its right to declare the loan in default.”
Conclusion
A borrowing base deficiency is a critical issue for businesses that rely on asset-based loans, as it can restrict access to necessary credit and create financial pressure. For SMB owners, it’s essential to monitor the value of assets pledged as collateral and understand the terms of their borrowing agreements to avoid deficiencies and ensure the business can access the capital it needs.
By actively managing their collateral, staying on top of their financial health, and addressing potential deficiencies early, businesses can maintain a good relationship with lenders and avoid disruptions in their access to credit.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.