Formation Funding Agreement

What Is a Formation Funding Agreement

A formation and funding agreement is an arrangement between two entities which unite into a partnership to ensure that one of the parties would infuse funds into the newly created entity. The parties can choose which entity they wish to form. In lieu of the funds, the partner who provides the same, receives fixed returns. Such a contract is considered low-risk as the funding partner is assured a fixed income as opposed to a private equity investment, where the returns depend on the value of the shares.

The recipient partner is required to use the funds only for the purposes stated in the agreement. The funds provided as a part of this contract need to be maintained in a separate account. A repayment date should be fixed when the funding needs are to be returned to the partner,  providing the funding.

Purpose of a Formation Funding Agreement?

The purpose of such a contract is to obtain finance for one’s venture without compromising on the equity. For the partner who provides the funds, such an arrangement assures fixed returns on his investment with a low amount of risk. Having a fixed date for the return of the finance also provides security to the partner providing the finance.

Inclusions in a Formation Funding Agreement

The document must necessarily include all the essential elements to be considered as legal and binding. Elements such as legally-capable parties, the proposed projects that are to be undertaken, the sources of funds, the time of the return of money and other standard boilerplate clauses such as effective date, notices, remedies, waivers and dispute resolution must be specified in the agreement.

The document should be reviewed by a lawyer or a professional who has extensive knowledge about the creation of a Funding Agreement. Further, the document must be registered and must be authenticated before a proper forum to make it compelling between the two parties.

Key Terms in a Formation Funding Agreement

A funding agreement needs to have the following key terms:

• Purpose Cause– The purpose of the funds is written in the agreement in order to restrict the use of funds to the purpose for which it is allocated.
• Drawdown Requirements-The funding agreement usually will specify a period during which withdrawals and drawdowns can be made subject to the satisfaction of conditions precedent.
• Repayment Formulas-The agreement also lists the mode of repayment and span of time over which the repayment is spread.
• Returns- The interest of return being drawn by the funding partner needs to be fixed in the agreement.
• Covenants– The usual covenants, both positive and negative, will be required for the agreement. Additionally, information covenants will also be required.
• Default Provisions– Funding Agreements include the usual kinds of events of default which will allow the lenders to cancel the facility, accelerate the loan, and exercise their rights under the security documents.

Drafting a Formation Funding Agreement

The following guidelines must be followed while drafting a funding agreement:

• The purpose of the funding should be as broad as possible. Having a narrow scope may prevent expansion and diversification at later stages.
• The timeline for return can either be a fixed date or a graded period of time. For example, A will return the funds to B in tranches. This can help the recipient partner by lowering the return in proportion to the money already paid.
• There can also be an option to convert this agreement into an Equity Investment Agreement in compliance with the applicable law. Such an option can be given to the funding partner.
• Dispute resolution clauses should be effectively structured and drafted as such an agreement creates a lot of scope for dispute.
• Remedies to the funding partner for non-payment of money should be included.

Benefits of a Formation Funding Agreement

A formation funding agreement has the following benefits:

• A fixed return of interest assures the investor and hence encourages them to enter into such contracts.
• The recipient partner does not have to compromise on his/her equity stake and hence feels more comfortable in such a contract.
• Having a written agreement mitigates the scope for disputes.
• Having an outlined purpose also streamlines the formation of the partnership.

Cons of a Formation Funding Agreement

Following are the cons of a funding agreement:

• A fixed return of interest sometimes even translates into lower returns. This is so because if the company is doing well and the share prices are soaring, the investor would not be able to avail benefits of the same.
• Having an outlined purpose sometimes, especially if the contract is ill-drafted prevents in diversification. For example, if the partnership opened with some other objective, but now wants to expand to other sectors, the fund cannot be used.
• There might be limited remedies for the funding partner if there is no repayment as no security interest is created.

A formation and funding agreement helps parties to create entities without worrying about finance. It brings together a person with ideas and a person with funds in order to create a business. Such agreements are, however, prone to disputes, especially over the return and repayment of funds. There should be specific remedies, and clauses which entitle the funding partner to recover his funds if it remains unpaid beyond the repayment date. The dispute resolution clause should also be drafted carefully with both – litigation and arbitration as the dispute resolution methods.

Sample for Formation Funding Agreement

A sample of the agreement can be downloaded from below.

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