Permitted debt: Overview, definition, and example
What is permitted debt?
Permitted debt refers to a specific category of debt that a company or entity is allowed to incur according to the terms of a loan agreement, bond covenant, or other financing arrangement. This type of debt is considered acceptable or permissible under the conditions set forth by the lender, investor, or governing legal agreement. Typically, a loan agreement will specify a set of conditions under which the borrower is allowed to incur additional debt without violating the terms of the original contract. These conditions can include debt limits, types of debt, or circumstances under which the borrower is permitted to take on additional financial obligations.
The goal of defining permitted debt in agreements is to give the borrower flexibility in managing its financing needs while also protecting the interests of the lender or other creditors by ensuring that the borrower does not over-leverage itself or take on too much additional risk.
Why is permitted debt important?
Permitted debt is important because it allows borrowers to access additional financing when needed, under specified terms that prevent them from overextending financially. By setting clear boundaries for the amount and type of debt a borrower can take on, lenders can mitigate risk and ensure that the borrower maintains a manageable level of debt.
For borrowers, having a clearly defined set of permitted debt limits in place ensures that they can pursue business opportunities that require additional funding (such as expanding operations or acquiring new assets) without violating their existing agreements. It provides flexibility for growth while maintaining the integrity of the original borrowing terms.
Understanding permitted debt through an example
Imagine a company, XYZ Corp., that has an existing credit agreement with a bank. The agreement states that XYZ Corp. is allowed to incur up to $10 million in additional debt, as long as certain financial ratios (such as debt-to-equity ratio) are met. If XYZ Corp. needs to borrow more money to fund a new acquisition, it can do so as long as the total debt remains within the permitted debt limit of $10 million.
For example, if XYZ Corp. decides to take on an additional $5 million in debt to finance the purchase of a competitor, this would be permissible as long as the total debt does not exceed the $10 million limit set by the agreement. However, if the company exceeds this limit, it would be in violation of the terms of the loan agreement, potentially leading to penalties or a default.
In another example, a company might be allowed to incur certain types of debt, such as trade payables or short-term loans, without restriction. However, long-term debt might only be allowed with prior approval from the lender or only in specific circumstances (such as after meeting certain financial milestones).
An example of a permitted debt clause
Here’s how a permitted debt clause might look in a loan agreement:
“The Borrower may incur additional debt under the following circumstances: (i) debt incurred in the ordinary course of business, including trade payables, (ii) debt incurred to finance acquisitions or capital expenditures, provided that the total debt outstanding does not exceed $10 million at any time, and (iii) debt incurred with the prior written consent of the Lender. Any debt beyond these limits will require the Lender’s approval.”
Conclusion
Permitted debt provides a framework for borrowers to access additional financing while maintaining compliance with their existing loan agreements. It ensures that both the borrower and lender understand the limits and conditions under which additional debt can be incurred, reducing the risk of financial strain or default. By clearly defining the types of debt that are allowable, permitted debt clauses provide flexibility for business growth while safeguarding the interests of creditors. For companies, it offers the opportunity to manage capital needs efficiently, ensuring that they can continue to operate and expand without violating critical financial agreements.
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.