So you’ve decided that loan finance is the way forward for your business. You have looked into other mainstream sources of funding such as asset finance, receivables finance, venture capital and private equity but none seem to suit your requirements as much as loan finance. You now need to focus on the precise type of loan facility and likely terms which may be available to you.
What are the critical issues you should consider and what outcomes should you seek? Loan documentation can be extremely complex. It may contain detailed assurances about how you will operate your business, reporting requirements and financial covenants with which the business must comply. All must be carefully considered. However the starting point should not be a line by line review of the precise wording used. Instead it should focus on the overall objectives you are seeking to achieve by obtaining loan finance and how any potential facility sits with those objectives. This article aims to set out the main areas to be considered in relation to this and to provide an overview of the manner in which a loan facility may affect them.
A wide range of issues can arise in relation to a proposed loan transaction. Some crucial ones include:
How much do you need?
If you need a lot of money (ie in excess of, say, £30 million) the loan may need to be provided by a syndicate of banks (or, at least, one bank with other banks participating behind the scenes by providing funding, or commitments to fund, to that bank). This spreads the risk amongst the participating banks which can result in a larger loan amount being available and the cost being less than if only one bank lender were providing the monies. However it can make the relationship between borrower and funder(s) more complicated, particularly where amendments to the facility or waivers of breaches are needed, because there are a greater number of participants whose views must be considered.
However, it is very much more likely that the sum your business requires is a six or seven figure sum and as such a single bank lender or a loan from another source, such as another trading company, private individual or other type of financial institution, will be more appropriate.
What type of loan do you need?
Do you need committed or uncommitted funding? A bank overdraft will provide uncommitted funding where the bank can decide whether or not to allow you to draw down funds and repayment of which can be demanded by the bank at any time. This is tempered slightly by the practice of having a review date for such a facility and there generally being an understanding that the bank will not call in the overdraft unless and until your financial position or activities cause it concern.
A committed facility will provide more certainty that the monies will be available for the term of the loan (subject to complying with the conditions of the facility). However a committed facility often attracts additional cost because commitment fees will be required during the availability period of the committed funding.
If monies for working capital are needed then consider whether this is core working capital which is always needed, in which case a committed facility would appear preferable. Where such working capital is not a constant requirement an overdraft can provide readily accessible cash to meet any temporary shortfalls in working capital.
Are the loan monies needed for purposes which will require funding on an on-going basis or for a specific one-off payment? If the former is the case then a revolving facility from which you can draw to an agreed limit (subject to complying with the terms of the facility) and where any repayments you make replenish that limit is likely to be more appropriate. If funding is required for a specific project where a known amount is needed then a term loan which provides a fixed level of funding at the outset, or in staged drawdowns over an agreed time period, will be more appropriate; for example, if you are constructing a new site or wish to purchase capital equipment.
The period for repayment should match the commercial requirements and abilities of your business. If the facility is repayable on demand then clearly careful thought needs to be given to how the business will repay should demand be made. Where you opt for a term facility the repayments required under it should coincide with the predicted cash-flows of the business. Such predicted cash-flows should be stress tested to see how certain they are.
The stability of the funding is also relevant here. The more easily the lender can call in the loan (assuming it is not repayable on demand in the first place) the more carefully the proposed repayment profile needs to be considered. For example where the proposed facility documentation contains wide-ranging situations in which immediate repayment can be demanded.
If you anticipate that there may be circumstances when you would wish to repay a term loan early, consider whether, and if so how, early repayment can occur under the terms of any proposed facility documentation.
The currentUKtax regime favours debt finance because interest (unlike dividends) is tax deductible. In addition to interest various fees may be charged. Such fees differ between types of facility and depend upon the lender's assessment of the risk they are accepting in lending the monies.
A range of fees may be charged. Possibilities include:
The likely overall level of cost should be carefully considered. For example interest on an overdraft may be at a higher rate than on a term loan. However in aggregate the overdraft may be cheaper because interest is calculated daily on the amount actually borrowed and commitment fees are not charged. The commercial flexibility which a particular facility may provide should also be considered. In broad terms the lower the cost the less flexible the facility is likely to be but a more flexible arrangement may be more appropriate for your business. Such flexibility may justify the additional cost.
Comment is made below on the need to make sure that appropriate internal controls are put in place to ensure that all terms of the facility are complied with. This is particularly relevant to reporting requirements and to ensuring that the business is operated within the parameters imposed by the facility because there are likely to be penalties for any breach. The internal cost of ensuring such compliance should also be considered as this can add to the overall cost.
The lender may (and these days probably will) require some form of security. Whether or not it does will differ depending upon the status of the borrower and the prospective lender's attitude to risk.
Very well established companies, ie large publicly traded companies, tend to be the only entities from which the lender will not require security. Such companies are of course in a tiny minority and "normal" borrowers therefore should assume they will be required to offer a comprehensive security package.
The most common security required by lenders is a fixed and floating charge (normally contained in a debenture document) over the borrower. This means all the assets of the company are potentially available to the lender to be sold should the loan not be repaid as required.
In many cases borrowers (and especially early stage borrowers) will have few assets and will be assessed by the lender as a poor credit risk. Accordingly, the lender would commonly then ask for additional personal security in the form of guarantees from directors or other interested persons as well as supporting security over personal assets, such as homes or life policies. This should of course be resisted if at all possible as it defeats the point of establishing a limited liability company. Some lenders might accept a comfort letter instead. This provides an indication, often from a parent company, of an intention to ensure that the borrower company will have adequate resources to discharge its liabilities. If such a comfort letter is available you should suggest this. Be that as it may, many lenders will not lend to growing companies without personal guarantees thereby leaving the borrower with no room for negotiation.
As with the facility agreement itself the terms of any security should be carefully considered to ensure that its terms do not restrict the business in a way which is commercially unacceptable or impractical.
If you are required to offer a personal guarantee then you should read the document carefully and consider the following:
Depending upon the nature of the facility, extensive representations, warranties and covenants may be included. A warranty is a contractual promise that a statement of affairs is true. A representation is a promise that the lender can rely on when deciding whether to lend. In both cases the lender can sue the borrower should such a warranty or representation turn out to be untrue (see below for further detail). These may cover a wide range of issues but with the following overall purposes in mind:
The representations are primarily intended to achieve two purposes for the lender. The first is to obtain information for the lender on the basis of which it can make its credit decisions. The second is to allocate risk between the borrower and the lender. If any representation turns out to be incorrect this will typically enable the lender to stop making further advances and will also trigger an event of default under the facility.
The lender will often wish to use the representations to maintain a consistent level of risk in its lending to the borrower, the idea being that the representations portray a picture of the borrower's position which should be maintained throughout the life of the facility. A number of methods might be used to achieve this including providing that:
Typical representations cover the following (amongst other matters):-
The lender will want to control the future activities of the borrower to the extent that such activities may affect the lender's position. Again this is effectively a risk control issue where the lender wishes to maintain a consistent level of risk in its lending to the borrower. The representations can contribute to this but the main method of doing so is by the inclusion of covenants in the facility agreement obliging the borrower to do or refrain from doing certain things during the life of the facility.
Covenants should be very carefully considered. They may have an impact on the day-to-day operation of the business which may restrict it in ways which may cause difficulties for the borrower. If they are breached this will be an event of default under the facility which may lead to acceleration of repayment of the loan. It may also lead to acceleration of repayment of other loans if they contain wording that it is a default under them if a default occurs under the loan facility. It may even cause the rate of interest being paid to be increased.
Covenants might be split into the following categories:
Financial covenants may be aimed at specific aspects of the borrower's business such as its overall worth, ability to cover the interest payments (known as the interest cover test) due under the facility or the relationship between the borrower's worth and its level of borrowing (known as the loan to value ratio).
As with all of the covenants and the other provisions of the proposed facility, attention should be given to how financial covenants may affect the development of the business in future. Consideration should be given to your objectives for your business during the life of the facility. What plans are there for growing or reorganising the business and what is it intended to look like over time? How will such plans affect its financial position including its overall borrowings? This is particularly relevant when considering whether or not particular financial covenants requested by the proposed lender are acceptable. It is important to ensure the terms of the borrowing truly suit your business now throughout the term as having to revert to a lender and renegotiate the terms of your borrowing can be time consuming and expensive.
The level of information to be provided to the prospective lender in terms of the administrative burden and any confidentiality issues should also be considered.
These will apply to on-going financial information (in the main up to date accounting information to allow the lender to assess performance against the financial covenants) to be provided to the lender by the borrower. The facility documentation will make specific provision for:
Provision will also be made for other information to be provided to the lender including:
C. Other restrictions
The facility documentation will also contain several further restrictions which may include limits concerning:
You should consider how such restrictions may affect your business and whether or not any exceptions are needed. For example that disposals of assets are allowed where equipment needs to be replaced or where such assets are below a certain value. Any exceptions negotiated should also be reflected in any security documentation which contains similar restrictions.
Put simply, a default is a breach of the terms of the facility agreement. While a default could relate to any breach, in most cases the documentation specifically sets out what will constitute an event of default. Chief amongst these will be breaches of the undertakings, restrictions and tests (e.g. interest cover test) imposed on the borrower. Once an event of default has occurred the facility agreement will proscribe what action the lender may then take to protect its position. Care must therefore be taken to consider the proposed facility agreement as a whole to ensure that it can be complied with.
The events themselves and the rights they give to the lender if they occur should be carefully considered. The events can cover a wide range of areas but common ones include:
In general an event of default will allow the lender to:
You should consider carefully how commitments entered into in facility documentation are to be monitored and satisfied. A checklist of the required information should be prepared. Large companies and groups will typically implement central reporting to ensure compliance with the terms in the facility. In smaller companies it is much easier to disseminate the relevant information, but the logistics still need to be considered and the directors should ensure a mechanism exists to ensure all relevant corporate actions that the company might undertake are permitted under the terms of the facility agreement. Failure to ensure that proper information is provided and that the activities of the business are monitored to ensure that they fit within the commitments undertaken could be costly. Such commitments may be wide and cover financial performance, asset disposals, third party claims against the business etc. and if not satisfied will give rise to events of default, possible acceleration of repayment of the facility and, ultimately, enforcement by the lender.
Care should be taken with any facility to ensure that it fits in with the commercial requirements and future plans of your business. If it does not discussions should take place with the lender or their advisers about making amendments which may overcome this (e.g. materiality provisions, cure or grace periods for putting right events of default or, where relevant, limiting provisions to specific parts of your group).
Once the terms of the facility have been agreed drawing up a list of reporting requirements and relevant restrictions can be invaluable in ensuring compliance with the facility agreement or at least identifying areas where requests for amendments or waivers of breaches should be made to the lender to avoid default.
Failure to consider the terms of the facility carefully and to plan for its operation can cause major issues for your business, at worst contributing to its failure and at best talking up valuable management time in dealing with the problems inappropriate facility terms can cause.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.