Deposit Account Control Agreements (DACA) in Startup Funding and Startup Banking
Given that you’re reading this article, you’ve likely been presented with a DACA (deposit account control agreement) and you have questions—if that’s the case, great, we’re here to help! DACA requirements are fairly common nowadays for startups raising either debt or equity capital, as they enable lenders to hedge their risk. They’re often used alongside tranches, which enable lenders to split their capital investment, and only disburse payment once the outlined milestones are reached. In this post, we cover the basics of deposit account control agreements: what they are, how they work, and why they’re used, then we jump into some of the key elements and terms you may come across when negotiating a DACA—let’s dive in!
An overview of deposit account control agreements (DACA)
Deposit account control agreements (DACA), also known as "lockbox agreements," "control agreements," "account control agreements" or "ACAs", are legally binding agreements between startups, their bank, and a lender or capital provider. DACA agreements allow lenders to maintain control over their funds even after depositing them into a startup’s bank account. They can choose to freeze the account, collect the funds, and use them to pay off the loan in the event of a default, or missed payment. You can think of DACAs as functioning similarly to redemption rights in equity term sheets.
In addition to the controls lenders have over the funds, some DACAs even specify the level of access that startups have to the borrowed funds in their accounts. For example, startups with “non-invoked” or “Springing” DACAs can access the funds, but startups with “invoked” or “blocked” DACAs cannot. Typically the specific access controls are established ahead of time, though it's important to note that depending on the terms of the agreement, the lender may have the ability to change the access levels at any time.
Deposit account control agreements help lenders minimize the default risk on the loans that they originate. If the startup fails to make a payment, the lender can invoke their right and collect either a portion of the loan or the entire outstanding balance. DACAs can also be used by lenders to automate the distribution of funds, which can be weekly, bi-weekly, monthly…etc.
The reason why lenders require startups to agree to deposit account control agreements
Lenders often require startups to sign DACA agreements to ensure that they maintain control over the funds that they are lending. Without a DACA agreement, the lender may not be able to collect the funds if the startup falls behind or defaults on the loan. DACA agreements also protect the startup, by ensuring that the lender cannot freeze the funding without proper notice.
To contextualize this, let’s say that a startup borrows $5M from XYZ firm (lender) to build out its new office space. XYZ firm establishes a “non-invoked” deposit account control agreement at the startup's bank and funds the loan. The startup pulls $3M from the loan to purchase office space that it had previously signed an LOI on. Two weeks later the startup begins renovations on the property and pulls an additional $1M.
Then let’s say the startup starts pulling on the remaining $1M for software subscriptions, advertising placements, and other non-related expenses. The lender confronts the startup and changes the DACA to be “blocked”—as such, the startup can no longer openly pull funds without the lender's permission. The startup makes the first two monthly payments, then misses the third. The lender then decides to invoke its rights, retrieving the remaining funds in the account, and requests that the startup prematurely repays a portion of the loan. In this scenario, the DACA worked as intended by protecting the lender.
DACA account requirements and the uniform commercial code
The Uniform Commercial Code (the UCC), is a comprehensive set of laws governing all commercial transactions in the US. It’s not a federal statute or law, though it is universally accepted across all 50 states. The UCC ensures that startups can enter into standardized contracts with others knowing that the terms of said agreement will be enforced in the same way by the courts of every jurisdiction throughout the US. Deposit account control agreements must comply with the UCC, more specifically Article 9, which is related to the control of deposit accounts.
The key elements of a DACA agreement
There are a few key elements of deposit account control agreements that startups should be aware of before entering into one, they include:
- The status of the DACA - as mentioned above, DACAs can be either active, also called “invoked” or “blocked”, or passive, also called “non-invoked” or “springing”. In the former only the lender can distribute the funds, in the latter case, both the startup and the lender can distribute the funds.
- The terms of the DACA - also as mentioned above, some DACAs enable lenders to prematurely call the entire balance of the loan in the event of a single mispayment, while others require several mispayments.
- Notifications - lenders are required to notify borrowers of any changes to the DACA and any actions they may take to prematurely recover funds if DACA is triggered. Typically, lenders must provide at least 48 hours notice before taking action.
- The DACA bank account - is the only account that the lender has control over, they can choose to freeze the account, collect the funds, and use them to pay off the loan.
Definitions of key terms that you may come across when presented with a deposit account control agreement
- Active DACA — As mentioned, active DACAs enable only the lender to disburse funds, not the borrower.
- Debtor — The debtor is the startup that receives the funding in their account.
- Disposition Instruction - These are instructions to the bank provided by the lender, that direct the distribution of funds in the account.
- Initial Instruction — These are instructions to the bank, which restrict the ability of the borrower to initiate distributions.
- Passive DACA – As mentioned above, passive DACAs enable both the borrower (startup) and the lender to distribute funds.
- Perfected Security Interest — these interests grant the lender exclusive control over the control the startup's bank account.
- Secured Party — This is the name of the partner (the lender) who has exclusive control over the startup’s bank account.
- UCC § 9-104 — This is article nine of the Uniform Commercial Code, related to the control over deposit accounts that applies to all DACAs.
Final thoughts on deposit account control agreements (DACA) in startup funding and startup banking
DACAs are essential for protecting the interests of both lenders and startup borrowers. They ensure that everyone is in alignment and understands the consequences of a default event. Before entering into a deposit account control agreement, consult legal counsel to make sure that you understand all of the terms and trigger events. Before defaulting on a loan, consider reaching out to the lender well in advance to limit the potential of a recall request.
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