Business Borrowing Basics – Negotiating A Loan Agreement

The Art of the Business Loan Agreement

Cash is king for businesses, especially those just getting off the ground. It’s rare that a company can simply operate from cash flow without short-term borrowing from time to time. A loan agreement is necessary, and being able to negotiate its terms is equally important.

Even if your business does not have a line of credit – or, another type of loan with a bank or other professional lender (e.g. credit unions, non-bank asset based lenders, etc.) – it nonetheless borrows every time it buys on credit, defers payables or pays its employees in arrears.

Often, access to credit makes the difference in whether a business survives.

However, there is a cost to obtaining any credit facility beyond interest and fees charged. The terms of any loan, and the restrictions it places on borrowers, can often determine how much of a benefit (or burden) any loan facility places on a business.

• How much borrowing is available?
• What will the collateral be?
• How much reporting must the company undertake?
• What restrictions does the loan agreement place on running the business?

All these terms (and more) are often open to negotiation, regardless of whether your lender suggests otherwise.

As Wade Kennedy of McGuire Woods puts it: “In a business loan, there is nothing more important than a flexible, positive relationship between borrower and lender, but circumstances change, as do the bank personnel, and the parties can only truly rely on the terms expressly agreed to in the loan documents.”

Business Loans: Why Negotiate Detailed Terms?

The short answer: If the details matter (and they always do), you should negotiate the best terms you can.

In most loan facilities, you can expect to see some or all of the following legal documents:

1. Loan and Security Agreement (may be two separate documents)
2. Guarantees (personal or corporate)
3. Stock (equity) Pledge Agreements
4. Reporting Documents (Compliance and Borrowing Base Certificates)
5. Account Control Agreements (giving lender control over deposit accounts)
6. Landlord Waivers/Access Agreements

Many lenders in the middle market offer loans documented on standardized forms. They use broadly restrictive terms and a “fill in the blank” structure.

This approach provides significant savings on legal expenses, but these standardized forms contain one-sided terms favorable to the lender.

Such terms might inadvertently saddle your business with covenants and representations you often cannot keep—and to which you should not agree. If your business wants or needs greater flexibility (and the prospect of more favorable terms), a negotiated set of nominally “customized” loan documents is the typical approach you should take with your lender.

Most lenders are willing to negotiate a package of loan documentation, so long as the process begins with a set of base “forms” with which the lender is familiar. A borrower can obtain significant benefits and concessions from most lenders beyond the basic economic terms of the loan (interest rate, term, security, and fees). The ability to negotiate these terms depends on:

• The creditworthiness of the business
• The presence of competing lenders
• The market conditions

Borrowers should keep in mind that lending institutions are like any other business, because they need customers. If more than one lender is willing to loan to your business, then you have some leverage.

Business Loans: When Should I Start Negotiating?

The short answer: Immediately.

A proposal letter (or commitment letter) and term sheet are typically the first documents a lender will ask a borrower to sign, but likely the negotiation of the loan agreement has already begun with phone calls and emails.

Also, the term sheet will be the first document that goes beyond the basics of pricing, tenor and fees. It delves into terms relating to scheduled payments and prepayments, collateral, closing deliveries, financial covenants and events of default—and that is when negotiation should begin in earnest.

A lender will hold you to the terms set out in an agreed term sheet, and that is when a borrower should engage counsel. Begin thinking all the way through the transaction, as well as its documentation and structure.

“There is nothing wrong with accepting general terms that are “market” for similarly situated borrowers,” Kennedy says. “A smart lender will not present terms it knows a borrower has no reason or ability to comply with. It can be a financial (and sometimes strategic) mistake to try to negotiate every provision in a loan document.”

Negotiate the Most Important Provisions

Legal counsel can help guide the borrower through the loan documentation and point out those provisions that typically are most important to the company.

In many instances, the term sheet outlines these very effectively, but the detailed terms must “work” with the borrower’s business and operating requirements. You should be able to ask and answer many questions.

• Can I borrow money and get the proceeds when and how needed?
• Can I provide the financial reporting with the frequency and detail required?
• Do the covenants allow me to enter into transactions I know I need?

If the answer to these and similar questions is “no,” then that is likely an area for negotiation. Everything else probably falls into the “nice to have” category, but is not worth going to the mat over.

One corollary to all this is that it always makes sense for a business owner actually to read the loan agreement they are signing. This may sound obvious, but skipping over “boilerplate” or relying too much on legal counsel to review business terms often results in documentation contrary to how an individual business runs.

This is what you want to avoid.

So, a strategy that focuses on the most important provisions tends to be the most cost- and time-effective. Business owners can save a lot of money on attorney fees by limiting the negotiation to a few key items, and this strategy also cuts down on time to close.

Engaging an experienced attorney in the type of loan you seek—and one that is willing to take some time to learn about your business—goes a long way to creating an efficient approach to negotiating and closing a loan agreement.

General inexperience, not knowing the “market” for your specific type of loan or simply wanting to appear to be doing an effective job, can all result in “over-lawyering.” To avoid this, ask questions of your attorney both up front (such as “Have you negotiated many of these types of deals recently?”) and throughout the process (such as “Why do I need this provision?”).

Good counsel will always happily explain their expertise and the reason for and importance of the specific terms to which you agree.

Common Provisions to Negotiate

As noted above, the term sheet sets out many of the most important terms of a loan transaction, including the maximum amount to be borrowed, interest rates, repayment terms, fees and costs payable, collateral, key financial covenants and certain defaults.

The actual documentation provides more detail, but the usual points of critical interest to a borrower include the following:

• Borrowing mechanics (when and how borrowing notice is given, and when do you get your money)
• Calculation of the borrowing base (for asset-based loans)
• Eligibility requirements (and discretion to exclude accounts receivable and inventory from the borrowing base)
• Cash dominion (controlled accounts and cash sweep provisions)
• Calculation of EBITDA for financial covenants and related definitions
• Affirmative covenants (actions the borrower agrees to take in the future):e
  • Notice of adverse event
  • Delivery of financial information
  • Allowing lender to enter and inspect its premises and records
  • Compliance with laws and maintaining insurance
• Negative covenants (what the borrower agrees it won’t do in the future):
  • Incur other debt
  • Sell assets
  • Incur liens
  • Make investments
  • Make dividends
  • Dissolve or wind up the business

Terms that are important (i.e., they have to “work” with the borrower’s business) but are not necessarily negotiated heavily (mainly because they are fairly standard or “market”) include the following:

• Yield protection and tax provisions
• Representations and Warranties (what the status of the business is at closing)
• General payment provisions
• Defaults
• Waivers (jury trial, etc.)
• Applicable law and consent to jurisdiction

The Benefits of Negotiating

• The ability to trade for or modify terms
• Major upside with relatively little downside (the worst they can say is “no”)
• Assurance that the agreement is thought-out and vetted thoroughly

Potential Pitfalls of Over-Negotiating

• Both sides may incur additional costs (including time spent).
• It’s possible to begin a banking relationship on a sour note.
• Even if you negotiate successfully, some items may never come into play.
• Thorough vetting may eliminate wiggle room or space for interpretation.

Balancing Business vs. Legal Considerations

The main issue is one of cost and necessity.

Let’s compare it to buying a car.

You can get the base model (the one in the ads), with stock four-cylinder engine, no options and only the most basic safety and convenience features.

You may save money, but risk being really unhappy when you realize air conditioning, anti-lock brakes and a back seat were options you didn’t get.

Or, you can find a mid-level model on the lot with the special features you need (i.e., integrated child seat if you have kids; four wheel drive if you drive off road, etc.). It’s considerably more expensive, but your vehicle better suits your needs.

The final option is to have a car built for you from the ground up. You can dig into the nuts and bolts of every aspect of the vehicle—from engine size to upholstery to pin striping and racing foils. It may be the car you always wanted, but did you really need spinning rims, a 24-speaker sound system and underbody fluorescent lights?

Probably not.

So, back your loan facility.

For some borrowers, a form “fill in the blank” loan document is perfectly acceptable.

This has minimal changes to reflect the correct name and corporate structure of the borrower (and its subsidiaries and affiliates).

You still need a lawyer to review and explain the document, but with minimal time and expense (probably less than $2,000, depending on the attorney’s hourly rate).

But beware, this type of loan may contain onerous and narrow restrictions on how the company can run its business and, most importantly, provides maximum flexibility for the lender to withhold credit or declare a default—and withdraw the line entirely if any conditions change.

The other extreme is a truly customized loan agreement.

Here, you negotiate the scope and content of every provision (whether or not you really expect to have a critical need down the road). The main issue is asking permission from the lender to deviate from the restrictions in the agreement. Detailed negotiation can provide greater exceptions (carve-outs) to general prohibitions in the off-chance you need them in the future. This, however, takes time and creates expense for both you and the lender (remember you will be paying the lender’s legal fees as well as your own). These risks you address only have a small probability of arising.

So, for most businesses, a better approach is to stick to the “floor model.”

Ask for the things you really anticipate needing (“We need more time to deliver monthly financial statements, and we need more availability in the fall when production ramps up.”) but leave the rest to a “market” approach (i.e., if you don’t foresee needing a lot of additional capital for acquisitions, don’t ask for an pre-agree incremental facility increase and a detailed definition of permitted acquisitions).

Just remember: You do only get what you pay for. Expect some time and expense while your attorney fights with lender’s counsel over what special terms you need and how they work. Getting these details right at the outset avoids time and expense (and lender fees) down the road.

Pros & Cons of Ambiguity in a Loan Agreement

Obviously, some terms in a loan agreement require certainty and precision.

• Exactly how much can I borrow?
• When exactly is the loan due?
• What exactly is the interest rate I will pay?
• What is the cost of the loan, and what fees will the lender be entitled to?

These are all questions that should be readily answerable. Other terms are more ambiguous—whether by necessity or choice. Even questions about financial calculations are part art and part science.

A few such examples in loan documentation include:

• Timing of Deliveries and Notice – promptly” versus “within 3 business days”
• Compliance – “in all material respects” and “material adverse effect”
• Borrower Discretion – “reasonable business judgment” and “ordinary course of business”
• Lender Discretion – “sole discretion” and “permitted discretion”
• Events of Default – “Material adverse change”

Look for those areas in which you may be hamstrung by imprecise terms. If negative covenants only permit an action taken “in the ordinary course of business,” the borrower should be comfortable making that call. If the lender enjoys wide discretion in excluding collateral from the borrowing base or determining if a default has occurred, the borrower should ensure it has a good working relationship with the lender.

At the end of the day, negotiating excruciating detail into the loan agreement will be expensive and the borrower should decide if that is worth the cost.

To a certain degree, accepting a loan from a lender is an act of trust – for both parties. The lender entrusts the borrower to comply with the loan agreement (the lender’s faces limited options once you finalize the loan, and enforcement is expensive and time-consuming). The borrower entrusts the lender to be reasonable and flexible in managing the loan (there are always many discretionary “hooks” upon which to hang a default or limit credit, should the lender so choose).

Kennedy concludes: “Getting the critical terms agreed too early avoids costly adjustments in documentation and structure down the road and sets core expectations at the outset. It also doesn’t hurt to let your lender know you mean business and expect thoughtful terms. They can’t just throw in the kitchen sink and expect that you will agree. It says ‘I want a market deal here and I’m willing to work for it.’”

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basic Concepts Applicable to All Borrowers & Lenders and What Kind of Loan? This is an updated version of an article originally published on March 7, 2017.]

©All Rights Reserved. March, 2020.  DailyDAC™, LLC d/b/a/ Financial Poise™