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Negotiating Loan Documents for Borrowers – Part II

Understanding Loan Options

Access to capital is critical to every business. Entering into loan arrangements with a lender is a complex process, the results of which can be vital to the success or failure of a company. This is the second in a series of articles intended to explain various aspects of the loan process. In our first article, we discussed the importance of the term sheet stage of a loan transaction. In this article we take a step back and discuss factors for the prospective borrower to consider in choosing a loan and the types of loans that are available.

Debt financing offers an attractive alternative for many businesses as it avoids diluting equity interests, and a company’s taxable income may be reduced by interest payments and certain fees.  In addition, for many businesses, equity financing may not be available. Of course, debt financing is not without risks as debt financing can be expensive and the inability to repay the loan when due can result in the loss of assets pledged as collateral or force the business into a restructuring proceeding.  Accordingly, it is important for a borrower to consider many factors when determining whether to incur debt to finance its business, including the following:

  • Amount Required – How much money does the business need? What are the financial projections for the business? A borrower needs to be comfortable that it will be able to repay any amount borrowed when it is due as well as make any interim debt service payments for interest, fees or other expenses.
  • Use of Proceeds – A borrower needs to determine how it is going to use the money it borrows. Short-term debt financing is typically designed to provide a business with working capital, whereas long-term debt financing is often used for the acquisition and maintenance of fixed assets, such as property or equipment.  The lender will often seek to include a covenant in the loan documents that specifies how the loan proceeds may be used.  Different types of loans suit different spending purposes.
  • Access to Capital – Does the business need the full amount of the loan upfront or can it access funds that are drawn down over time as needed? If the money is not fully provided at the outset of the loan, the borrower will need to understand what restrictions may apply to the ability to draw down funds in the future.
  • Interest Rate – The interest rate on a loan may be fixed or variable. A fixed interest rate remains the same throughout the term of the loan whereas a variable interest rate may fluctuate either up or down. Lenders will often set a floor for variable interest rates to prevent the rate from dropping below a certain level. The amount of the interest rate will largely depend on the creditworthiness of the borrower and the value of collateral in relation to the loan amount.
  • Repayment Terms – Depending on the terms of the loan, principal payments may need to be re-paid in installments over time or the entire principal balance may be due at maturity. In addition, some events may trigger the earlier repayment of a portion of the outstanding principal amount of the loan such as the sale of assets outside of the ordinary course of business, the receipt of insurance proceeds or the receipt of funds from the sale of debt or equity securities. Some loans permit voluntary repayment of all or a portion of the principal amount of the loan at any time, while some may require a prepayment penalty or will only permit the loan to be repaid in full. In addition, the borrower needs to understand whether any principal amount that is repaid prior to the maturity date can be re-borrowed.
  • Collateral – A loan may be secured or unsecured. If the loan is secured, it means that the lender has a security interest in specified assets of the borrower and, possibly of any guarantors. The lender will have a right to the collateral if the borrower defaults on the loan.  Collateral may include any property, including real estate, inventory, equipment, unpaid receivables, cash, or a blanket lien on all assets. A borrower’s ability to grant a security interest in its assets may be restricted by the terms of any existing indebtedness. 
  • Restrictions on Additional Indebtedness – Will the business need access to additional capital in the future? Loan agreements will often contain restrictive covenants as to the ability of the borrower to incur other debt. Accordingly, it is crucial that the borrower understand any such restrictions and negotiate at the outset any exceptions that are expected to be required during the term of the loan.

Loans come in a variety of forms with varied terms, ranging from simple promissory notes among related parties to more complex agreements with banks and other lenders. Loans vary by length of time, how interest is calculated, when payments are due along with a number of other factors.  The reason for so many different loan products is the intended use of the funds and the creditworthiness of the borrower.

Types of Loans

  • Line of Credit – Under a line of credit, a borrower can draw down funds up to the amount of the credit limit. Interest is only charged on the amount outstanding under the loan, although lenders will often also charge an unused line fee for making the line of credit available to the borrower. Funds repaid under a line of credit can typically be re-borrowed.
  • Term Loan – A term loan is a common form of business financing whereby the borrower receives a lump sum of cash up front and repays the loan with interest over a predetermined period.
  • Asset Based Loan (ABL) – A type of loan that is secured by the borrower’s assets. Most asset based loans are structured as revolving lines of credit with the amount that is available to be borrower tied to the value of the available assets. Lenders advance funds based on an agreed percentage of the secured assets’ value. Such loans may be secured by inventory, accounts receivable, equipment, or other property owned by the borrower.
  • Accounts Receivable Loan – Also known as a factoring loan, accounts receivable loans enable a borrower to receive cash in advance of collecting a receivable. The borrower essentially sells the receivable to the lender at a discount, who is referred to as the factor, and the factor then collects the full amount of the receivable. This is often a more expensive form of financing compared to other options. The lender typically receives a security interest in the borrower’s receivables and inventory. It is important for the borrower to understand which receivables will be considered eligible receivables for purposes of receiving advances under the facility.
  • Equipment Financing – Equipment financing is a form of loan used to purchase a particular piece of equipment, which serves as collateral for the loan. These loans often require a down payment towards the purchase of the equipment. The term of the loan is typically based on the expected useful life of the equipment, but the term may outlast the useful life of the equipment.
  • Mortgage Loan – A mortgage loan is a loan that is secured by real property. It may be used by the borrower as a means to acquire the real property or to provide liquidity by borrowing using the real property as collateral.
  • Construction Loan – A construction loan is typically a short-term loan that is used to finance the construction or renovation of improvements upon real property. Typically, the proceeds of such loans are released over time by the lender to the borrower upon the completion of certain pre-determined milestones.
  • Mezzanine Loan – A mezzanine loan is a form of financing that is subordinated to a senior loan. Such loans are often convertible into equity interests of the borrower.  As there is a lender with a senior security interest in the assets of the borrower ahead of the mezzanine lender, such loans typically carry a higher interest rate than senior debt and require additional work to address intercreditor issues or concerns.

Debt financing can be vital to the ongoing operations of a business and a powerful expansion tool, but it is critical that a borrower select the right type of loan to meet its needs and that the borrower understands the potential restrictions that such debt may place on its operations.  Borrowers and prospective borrowers are encouraged to work with their legal and financial advisors in making such decisions as the lender will become an important stakeholder in the borrower’s business.

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