Emerging intercreditor issues in venture debt transactions: Key trends

Intercreditor issues are front of mind for many participants in the venture lending space. Lenders have become increasingly focused on contractual downside protections amid the challenging macroeconomic environment, and emerging growth companies have grown more creative when sourcing and structuring financing solutions due to the slowdown in venture capital activity.

In this alert, we highlight some frequently negotiated points in intercreditor agreements for venture debt transactions, and we offer suggestions for lenders to consider when evaluating them.

Intercreditor agreements

At its simplest, an intercreditor agreement defines the relative rights of two or more lenders to a borrower. The terms of these agreements vary based on the transaction structure (such as whether the lenders are using a split-collateral structure or first lien/second lien structure) and the relative bargaining power of the parties. They generally cover:

1. The payment priority of each lender’s obligations
2. The priority of each lender’s lien on its collateral, and
3. Each lender’s ability to exercise remedies following an event of default (and take action during a borrower’s bankruptcy).

Negotiations can be complex and contentious, and this dynamic is only exacerbated by lenders’ heightened sensitivity to credit risk in recent market conditions. Since the market disruption in early 2023, we have seen lenders more heavily negotiating intercreditor terms related to (1) permitted payments, (2) the junior lender’s purchase option, and (3) the lenders’ respective rights to exercise post-default remedies. These terms are discussed in more detail below.

Permitted payments

Payment subordination determines when a given lender may receive payment on its debt. Some transactions (including many using a first lien/second lien structure) may not provide for any payment subordination, meaning that the junior lender has an equal right to payment as the senior lender. On the other end of the spectrum, “deep” subordination prohibits the junior lender from receiving any payment on its debt until the senior lender is paid in full. This is often the case for convertible notes.

Between these two extremes is a wide range for negotiation. Prior to a default under the senior debt, payments to the junior lender for fees, expenses, and regularly scheduled payments of interest and/or principal are commonly permitted. Catch-up payments after any blockage period in which the junior lender was prohibited from receiving any payments are also permitted on occasion, but much less frequently.

Perhaps spurred by the difficult economic backdrop, junior lenders are pushing to broaden the scope of permitted payments. Creative junior lenders may now seek to receive payments after the occurrence of certain milestones, after the satisfaction of certain financial conditions, or both.

Esoteric requests are often deal specific and highly context dependent, so it is important for both lenders to have a clear understanding of the terms of each credit facility, as well as of the underlying credit modeling. For example, a regularly scheduled repayment of principal on the junior loan (which is often permitted by the senior lender outside of the context of “deep subordination” arrangements) may be problematic from a senior lender’s perspective if the junior facility requires bullet payments prior to maturity of the senior debt.

In all cases, exceptions to the general prohibition on payments to junior lenders should reflect the junior loan’s contribution to achieving the borrower’s objectives (eg, fueling growth, bolstering its balance sheet, acquiring equipment or other assets) and the impact that such payments will have on the borrower’s ability to repay the senior loan if the desired result is not achieved.

Purchase option

Another point often negotiated between lenders is the purchase option, which permits the junior lender to purchase the senior lender’s loan upon the occurrence of certain trigger events. The purchase option is not universally included in venture lending transactions but provides additional flexibility to a junior lender when its interests and prospects of recovery may diverge from that of the senior lender.

For example, a junior lender may be willing to delay payment in the hopes of obtaining a better recovery, whereas the senior lender (which has a higher priority claim to the collateral) may be willing to focus on speed of recovery at the expense of the total recovery for all the borrower’s creditors. The purchase option enables a junior lender to mitigate the deeper subordination terms to which it is subject if the senior lender is being overly accommodating to the borrower at the expense of the junior lender’s interests. Once the purchase option is exercised, the junior lender can drive negotiations with the borrower and control the exercise of remedies, while the senior lender is “made whole” through its receipt of the purchase price.

Common triggers may include:

1. The acceleration of the senior loan
2. The commencement of insolvency proceedings by or against the borrower, and
3. The occurrence of one or more defaults under the senior credit facility.

Parties can, and do, negotiate for additional trigger events.

Once a trigger has occurred, the provisions typically require the junior lender to affirmatively and irrevocably elect to exercise its option within a specified time period. Most arrangements require the purchase of all senior loans at their par value and may also require the junior lender to purchase additional obligations owed to the senior lender. These may include any bank services obligations and swap obligations.

Lenders proposing or assessing terms for a purchase option are encouraged to ensure that the triggers are limited to scenarios in which it is appropriate for the senior lender to be taken out of the borrower’s capital structure. Oftentimes, the borrower may also have a view, given the impact this can have on the borrower’s ability to work through a downside scenario – particularly for credit facilities with highly relational aspects.

The remainder of the purchase option provisions are largely mechanical, but are no less important, as ambiguity can lead to challenges for unwary lenders given the circumstances in which the purchase option is exercised. A well-drafted provision will clearly spell out the substantive and procedural details of the purchase, including the timing required to close the purchase, and the effect of the transaction. In many cases, a pre-negotiated form of the required assignment agreement will be attached as an exhibit to the intercreditor agreement, which can help sidestep issues that might arise in potentially delicate negotiations in a distressed scenario.

In any event, lenders are encouraged to carefully consider the terms and procedures set forth in the agreement to confirm they align with their commercial expectations and any operational needs.

The “most aggressive lender” remedies provision

Control over the exercise of remedies has historically been a hotly negotiated point in intercreditor agreements. In first lien/second lien structures, negotiations typically center on the extent to which junior lenders are willing to restrict their ability to exercise remedies. In pari passu co-lender structures, we are seeing more parties agree to a “most aggressive lender” construct, whereby the lender favoring the stronger enforcement action is entitled to control the exercise of remedies, given that the lenders are unable to agree on the appropriate enforcement action.

Proponents of this approach argue that it encourages consultation and coordination between lenders while ensuring that each lender will be able to take the actions it views as necessary if the borrower experiences distress in the future. Such is not the case if the exercise of remedies is based on a “required lender” or similar voting threshold, which are often disfavored by the minority lender whose enforcement rights would effectively be ceded to the majority lender. These proponents might also point to the inefficiencies of having multiple lenders pursue enforcement actions with respect to the same collateral.

However, others take a less favorable view of the most aggressive lender approach. Some borrowers, for example, argue that granting control of remedies to the strictest lender creates a race to the courthouse. Similarly, some lenders might seek to strike a different balance between the competing needs of coordination and autonomy in enforcement scenarios.

These lenders sometimes propose a construct whereby all lenders are subject to a mutual standstill period (akin to the restriction frequently placed on a junior lender in a first lien/second lien structure), after which either lender may exercise remedies independently. Similar to first lien/second lien structures, the standstill period is meant to provide breathing room for the parties to reach an agreement on the appropriate steps forward. However, in these contexts, the period is typically much shorter as the standstill is mutual, and the lenders’ respective interests are generally more aligned than in first lien/second lien structures.

For more information, or if you have any questions regarding the topics discussed in this alert or related matters, please contact one of the authors or another member of DLA Piper’s Venture and Growth Lending team.