Equity cure: Overview, definition, and example
What is an equity cure?
An equity cure is a mechanism that allows a borrower to avoid default on a loan or financial agreement by injecting additional equity (funds or assets) into the business. This typically occurs when the borrower fails to meet certain financial covenants or requirements, such as maintaining a specified level of profitability or debt-to-equity ratio. By providing new equity to the company, the borrower can rectify the financial situation and bring the business back into compliance with the terms of the agreement, preventing a technical default or breach.
For example, a company may have a covenant requiring them to maintain a certain level of net worth. If the company falls short of that threshold, they can use an equity cure by bringing in additional capital from shareholders or investors to meet the requirement.
Why is an equity cure important?
An equity cure is important because it provides businesses with a way to remedy financial covenant breaches without triggering default or facing severe penalties. It gives businesses flexibility, especially during times of temporary financial strain, by allowing them to rectify their financial standing quickly through new capital investment.
For lenders, an equity cure mechanism can offer reassurance that the borrower is taking proactive steps to address financial challenges, thus reducing the risk of default. For businesses, it offers a lifeline to avoid loan acceleration or other enforcement actions, enabling them to continue operations without major disruptions.
Understanding equity cure through an example
Imagine a company that has a loan agreement that includes a covenant requiring them to maintain a minimum level of equity. Due to a recent downturn in sales, the company's equity falls below the required level. Instead of defaulting on the loan, the company raises additional funds from its shareholders, increasing the equity in the business. This equity infusion satisfies the covenant, effectively curing the breach and bringing the company back into compliance with the loan terms.
In another example, a startup with a venture capital investment might be required to maintain a certain debt-to-equity ratio as part of its loan agreement. If the company is struggling to meet this ratio, the investors may inject additional funds into the company to ensure that the required ratio is met, preventing a default.
An example of an equity cure clause
Here’s how an equity cure clause might appear in a loan agreement or contract:
“In the event the Borrower fails to comply with any financial covenant, the Borrower shall have the right to cure such non-compliance by injecting additional equity into the business. Such an equity cure shall be executed within [X] days of the breach, and the Borrower must provide evidence of the equity infusion to the Lender to restore compliance with the applicable covenant.”
Conclusion
An equity cure is a financial remedy that allows businesses to avoid default by injecting additional equity into the company to meet financial covenant requirements. It provides flexibility for businesses to address temporary financial setbacks without triggering severe consequences like default or acceleration of debt. For businesses, equity cures are crucial tools for maintaining financial stability, while for lenders, they offer a way to ensure that borrowers are taking the necessary steps to remain in good standing.
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.