Getting the Right Security Burndown Metrics on a Commercial Lease
Often times when we review a tenant, the question of a security deposit or letter of credit burndown comes up. In most cases, the process is based on lease commencement anniversaries so long as the tenant has not had a default event on the lease. But in other instances, tenants face unique circumstances that warrant a more careful review of the burndown provisions in order to protect the landlord. In these cases, landlords may want to impose specific financial metrics before burning down the security deposit or letter of credit. The goal of the terms is to ensure that the tenant's financial condition is durable before burning down any excess security. Burndown structures vary depending on a tenant's industry and capital structure, but in most cases the provisions should focus on the tenant's profitability and balance sheet. Below are a few examples of situations that may merit inclusion of burndown provisions.
Startups and Venture Backed Companies
To be clear, few companies are thrilled at the prospect of handing over a security deposit or letter of credit. That pain is even more acute for startups that depend on cash to sustain and grow the business. When considering metrics for a startup's burndown, incorporate the company's anticipated growth milestones. These milestones are likely to be aligned with investors' growth expectations; and if a startup reaches key milestones, its future looks a little brighter. These milestones will vary from company to company, but they could include items like revenue targets, user growth, cash generation, and market expansion. If the tenant is a later stage company, consider including liquidity events like a sale or IPO as a condition of the burndown.
Highly Leveraged Companies
What happens when your tenant is established, but it has a lot of debt on the balance sheet. Without painting too broad a brush, it is important to know why the company has debt. Sometimes the company is part of a private equity firm's portfolio. Other companies may have borrowed to expand, make capital improvements, or buy inventory. Knowing the reasons for the company's debt can help to better define the conditions for a burndown. Think about liquidity, profitability, and the company's debt service capacity when establishing metrics to reduce security.
Companies are like snowflakes, where no two are alike. There is no guarantee that the same burndown conditions will apply to two different tenants. When you work with TRA, we sift through these questions and define metrics appropriate for each individual tenant.
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