When raising venture debt, many startups encounter complex term sheet provisions. One such provision that founders should pay close attention to is the “Investor Abandonment Clause.” This clause, often included by banks in venture debt agreements, can have significant implications for a startup’s financial flexibility and long-term control.
What Is an Investor Abandonment Clause?
An investor abandonment clause allows the lender – typically a bank – to seek assurances from the startup’s investors when things look risky. Specifically, if a lender becomes concerned about a startup’s prospects, it can approach the investors and ask: “Are you willing to put more money into the company?” If the investors indicate they don’t plan to invest further, this response can trigger the investor abandonment clause, automatically putting the startup in default.
Why Do Banks Include This Clause?
Banks loaning money to venture-backed startups accept a substantial level of risk. The investor abandonment clause acts as extra leverage for the bank, giving the bank some control if things go south. By being able to call a default when investors aren’t willing to provide more capital, banks protect themselves from the risk of a startup running out of cash without a financial backstop.
What Happens If the Clause Is Triggered?
Once triggered, the investor abandonment clause can put the startup into default – regardless of its current cash position or performance metrics. In a default scenario, control typically shifts to the bank. The lender can enforce its rights, which may include:
- Demanding immediate repayment of the debt
- Forcing a sale of the company or its assets
- Mandating that the company raise more capital on the bank’s terms
Essentially, the bank can dictate what happens next, often removing options for the startup’s founders and board.
Why Should Startups Negotiate This Clause?
At Kruze Consulting, we advise our venture-funded startup clients to be extremely careful with investor abandonment clauses. Because these clauses give banks a powerful tool to declare a default – even when the startup is not actually insolvent – founders should treat them as high-risk terms.
Whenever possible, startups should negotiate to have this clause removed from their venture debt term sheet. If removal isn’t possible, try to limit the situations where it can be triggered or negotiate more favorable definitions and investor notice requirements.
Understand every clause in your term sheet
Investor abandonment clauses may seem like a technical detail, but they hold real power in venture debt agreements. Founders and CEOs should always review their debt term sheets closely and consult experts – including experienced startup attorneys and accountants – to make sure they’re not giving up unnecessary leverage to lenders.
