Deficiency Agreement: What It is, How it Works

Will Kenton is an expert on the economy and investing laws and regulations. He previously held senior editorial roles at Investopedia and Kapitall Wire and holds a MA in Economics from The New School for Social Research and Doctor of Philosophy in English literature from NYU.

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What Is a Deficiency Agreement?

A deficiency agreement is an arrangement in which a sponsor or another party provides a firm with funds to cover any shortfalls arising from working capital, cash flow, or revenue restraints, allowing the company to service its debt. A deficiency agreement will usually have a cumulative limit specified by the lending party.

A deficiency agreement may also be called a cash deficiency agreement or a make-up arrangement.

Key Takeaways

• A deficiency agreement is an arrangement in which a sponsor or another party provides a firm with funds to cover any shortfalls arising from working capital, cash flow, or revenue restraints, allowing the company to service its debt.
• A deficiency agreement will usually have a cumulative limit specified by the lending party.
• A deficiency agreement may also be called a cash deficiency agreement or a make-up arrangement.
• Deficiency agreements allow firms to avoid the possibility of default during difficult periods.
• These types of agreements will usually involve parties that have an interest in the company and want to see it continue operations in the long term.

How a Deficiency Agreement Works

Deficiency agreements allow firms to avoid the possibility of default during difficult periods. These types of agreements will usually involve parties that have an interest in the company and want to see it continue operations in the long term. For example, consider a situation in which one or more of a second party's products are not selling as well as anticipated. A deficiency agreement would allow the borrower to service its debt without the entire company risking default.

While a deficiency agreement will cover an entire company, it may be specified to protect a smaller aspect of the business. For example, a new project may have unstable cash flows and be unable to generate revenues until it reaches a certain level of operations. To prevent the project from failing, a deficiency agreement could provide it with enough cash until a revenue stream is established.

In project finance, especially construction, a cash deficiency agreement includes one party providing for the other up to a certain amount, so that the second party may temporarily alleviate its cash flow problems until profitability is restored. This arrangement is used to ensure there are enough funds to meet the project's fixed charges.

In the oil and gas industry, throughput contracts sometimes include a throughput and deficiency agreement component to facilitate indirect financing alternatives. A throughput contract is an agreement between two parties wherein a service or commodity is secured by one of the parties for a specified period of time. A business may use throughput contracts as an indirect form of financing for projects, by providing access to materials rather than actual money.