Keepwell agreement is the contract between the main business and its subsidiary that requires the parent company and its subsidiary firm to maintain solvency and to provide financial support throughout the duration of the agreement. Keepwell agreements are sometimes referred to as comfort letters in certain circles.
Keepwell agreements are generally signed for a particular period of time between the parent business and its subsidiary, especially when the subsidy branch or company are facing cash flow problems and problems in raising new funds to continue its daily operations.
When the keepwell agreement is signed the parent company agrees to providing complete or partial financial support to its subsidiary firm for a length of time until it can generate revenue on its own for daily operations.
The subsidiary benefits greatly as it will enhance and improve the all-important credit rating of the subsidiary company. A favorable credit rating would attract more lenders in general.
The Statement of Financial Accounting Standard requires that a keepwell agreement be treated as a loss contingency and be recorded as a guarantee.
Let us consider the example of a fictional company Sunshine Co. and its subsidiary as Rainbow Inc. This current subsidiary is struggling to run daily financial operations of the company and its financial difficulties is dearly costing beverage company ABC Inc.
To meet its daily expenses and production costs, it is estimated that it requires a loan of $2 Million. However, generating finance is difficult in a quarter when it has poor results and especially with a low credit rating.
Sunshine Co. the parent company would help this subsidiary Rainbow Inc by signing a keepwell agreement and helping them with financial stability that is required to continue the productions. The agreement would significantly improve the credit rating of Rainbow Inc and it can now attract more lenders to raise funds.
This is immensely helpful tool to rescue a subsidiary firm for a parent organization during times of financial difficulty. The parent company provides its subsidiary with financial benefits and improves credit rating. This would increase its overall credibility.
For subsidiary organizations that find it difficult to manage expenses, keepwell agreement is a necessary step to provide confidence for lenders that this firm could fulfill its duties and continue the operations.
Apart from these, the keepwell agreement could also be signed to improve the creditworthiness of a bond or other security. The responsibility is taken by the parent organization for maintaining financial stability of the subsidiary.