Investors, banks and other businesses may be willing to lend your company money or extend you some credit — but you need to beware of a cross-default clause as your company takes on debt.
Cross-default clauses are designed to mitigate the risks investors and lending institutions take when they deal with small businesses. But they can also make it harder for those small companies to weather the occasional financial hiccup.
What’s a cross-default clause?
Basically, a cross-default clause is a provision in a loan that automatically puts the borrower in default on one loan if they happen to default on another.
For example, imagine that your business needs to borrow money to scale up from two different lenders or investors. The lenders don’t want to compete to be repaid if the business hits rough financial waters, so they use cross-default provisions in each loan. If you default on your loan to Lender A, you automatically are deemed to be in default on your loan to Lender B — even if those payments are current — and vice-versa.
Cross-default clauses are typically used when multiple lenders are involved in business financing. They mitigate risk by giving both lenders equal priority for repayment. They are also frequently seen in complex construction contracts involving multiple lenders and service providers.
You can also end up in cross-default by accidentally violating one or more affirmative obligations in your contracts. For example, if one of your loan agreements requires you to maintain a certain dollar amount of business insurance and you let your insurance lapse, you would be in default to that loan — and any others connected through a cross-default provision.
Don’t sign a contract until you fully understand the risks
You’ve worked hard to build your business, so don’t take any chances when you’re trying to expand. Make sure that you have experienced legal guidance for all your business contracts.