Read the Loan Agreements! Here's What to Look For.
Back in the winter of 2009, I was in South Florida with a new client that had made most of the hot tubs that went into nearly every new condo during the South Florida real estate boom.
I say "had," because South Florida real estate had crashed and the factory was now idle.
Late in the afternoon of my first day on site, I was on a long phone call with an angry lender, based in Detroit. He went on an extended rant,
complaining that it had been years since my client had submitted a borrowing base report (that details working capital collateral often required in an asset based loan) and was also diverting
cash to other banks (i.e., not depositing the cash in his bank, where he could grab it). Both of which, he said, were in violation of the loan agreement. I talked to the CFO and he said the loan was a community bank loan, not an asset based loan
(which would require borrowing base certificates), and that my client had used local banks for years to take deposits from the local retail stores my client operated.
The next morning, I talked to my client's local insolvency counsel, a retired Detroit bankruptcy judge, who had read the loan documents and confirmed that, a.) no borrowing base is required and, b.) there is no restriction on opening bank accounts. I later reviewed the loan documents myself and, not surprisingly, found the lawyer to be correct. What was clear is that the lender hadn't read its own documents!
Lenders not reading their own documents are rare occurrences. Unfortunately, borrowers not reading these documents are all too common.
For one client that I was called in to liquidate, after an effort to sell the assets had failed, I had an upcoming meeting with its lender, that had called a default. I asked for a copy of the loan documents so I could read them prior to the meeting. My client balked, as they didn't want to pay me to read legal stuff, but then relented. My quick review of the loan documents found that the only way to default was to not issue timely financial reports, liquidate or close on a sale of the business or assets.
So, when we met the lender, I told them my client was not
liquidating and was going to continue operating while they undertook an expanded sales effort for their assets. They would continue to do so until they ran out of cash. Now, there is no default. (I could tell by the lenders' faces that they had been afraid someone might actually read the loan agreement.) What to look for when reviewing loan agreements
Loan documents, both the types of documents and what is in the documents, vary considerably by type of loan, size of loan, lender, type of borrower and the borrower's capital structure. The topic of loan documents is too vast by itself to cover in a newsletter. But, a few basics are well worth noting... Start by gathering the key documents:
the loan agreement, security agreement and any guarantees. The formal promissory note is important too, but most of the meat is typically in the loan agreement. Check the basics first.
- Is the loan term, interest rate and payments structure what you think it should be given your discussions with the lender?
- If you have a credit line based on working capital, is there a formula that determines how much you can borrow? How does the formula work and does it match your needs?
- If a customer pays one invoice late, say 90 days past due, does that mean you lose the entire customer's balance in the formula? If yes (this is common), do you have customers for which this term will be problematic?
In the loan agreement, look for the section with "security" in the heading.
- Are your accounts receivables clean? That is, are there old unresolved customer deductions that result in old, but small, open balances that take the entire account out of the formula? Often there are restrictions here on customer concentration, absolute inventory dollar limits, etc.
- What collateral is being granted to the lender? Does the section include everything or some things?
Are you, personally, or a related entity guaranteeing the loan?
- Has another creditor already been granted a security interest in some of the collateral? If you are obtaining a line of credit, those are typically based on receivables and inventory. If that lender also claims a security interest in equipment, real estate and so forth, then those assets can't be used as collateral for a secured loan from someone else.
The ability of you personally or these other entities to borrow is hampered to a degree if they or you are on the hook for such a guaranty. (In the personal finance world, as an example, your risk profile will increase and hence your borrowing rates, if you guarantee your children's student loans.) Look for a section with "affirmative covenants" in them.
This is the section that requires your company to do or maintain certain things.
- A common affirmative covenant is meeting certain financial ratios such as debt coverage. Do you have projections in which you have confidence, that show you will meet these ratios?
- Are you required to subordinate all future borrowing to this particular lender?
Look to the "negative covenants" section for things your company can't do.
- Lenders usually require periodic financial information be sent to the lender. Read this carefully. How much time to report do you have? Must annual financial statements be audited or reviewed? Must the financial statements be GAAP compliant yet you run your business on non-GAAP financial statements?
Typically, these include restrictions on taking on more debt, pledging any additional assets to others and making distributions to owners. Will these things be a problem for you? Look for a section that deals with default.
What constitutes a default? Must the lender give notice of default? How long does your company have to cure the default and what remedies does the lender have?
There's a lot more to look for, of course, but these are the basics. Two final thoughts
In addition to the meat of the agreements themselves, keep this in mind:
- Use a good attorney. Remember, these are legal documents. So have a lawyer read, or better still, negotiate them, too. A good attorney is one whose day-to-day practice matches up with your type and size of loan and your capital structure (other loans, term loans, etc.). A lawyer who works with your kind of documents on a frequent basis will also know the market for competitive terms and conditions. If your company is borrowing money to finance real estate, for example, make sure your attorney is well versed in these types of loans.
In short, while loan documents are indeed voluminous and boring (except to certain lawyers), they can and do have tremendous impact on both the operation and longevity of your business.
- Read the documents yourself - and review them periodically. Particularly when things don't go as intended and you are unhappy with your lender (the feeling is usually mutual at that point), review the documents. Do the documents require the lender to do what you want? Probably not. When the lender threatens to do something, or in fact does something you don't like, did you already agree the lender could take these particular actions, given the current situation? It's vital that you understand what you have agreed to.