Commercial Loan Transactions – A Deeper Dive

This article builds on an article published last fall in which we covered some basics of funding your business through a commercial loan. In that article we advised that you plan well in advance (90-180 days to be safe), prepare a lender package that summarizes your business operations and finances, and expect to personally guarantee all, or at least a portion of, the loan.

In this follow up article, we drill down on some particulars of the loan process, and offer practical tips for how to efficiently – and successfully – obtain a business loan.  Specifically, we’ll address negotiating term sheets, understanding the collateral for the loan, and budgeting.

Negotiating Term Sheets

In our prior post on this topic, we discussed the non-negotiable nature of loan documents – financial regulation and lending practices dictate 90% of the form and substance of the loan documents; fight them at your peril.  On the other hand, term sheets are highly negotiable and negotiated, and the terms on which you and the lender agree will dictate 90% of the economics of the relationship, so this is the stage in the loan process where you can get more bang for your buck.

More is Better.  There is nothing unethical about courting multiple lenders; pursue the lenders that best understand your business and try to get at least two term sheets for your loan.  Comparing terms and seeing how they respond to your requests during negotiation will tell you a great deal about whether you want to borrow money from them.

Sweat the Details.  You might find that reading through a 10-page term sheet is taxing, tedious, and flat-out confusing.  Term sheets are not onerous by design – rather, they demonstrate the broad scope of the relationship you’re beginning.  Routinely when we see 3- or 4-page term sheets, it’s a sign that our client has not fully considered all contours of the lender’s offer.

Don’t Go It Alone.  Lenders operate based on internal approvals by their credit committees; once the term sheet is signed, the deal is baked, and getting changes agreed could jeopardize the loan.  During term sheet negotiation is the time to get your attorney involved; you’ll get the benefit of their counsel on deal terms and structure, and it will expedite the closing process.

Collateral

For any commercial loan of material size, you can expect the lender to require the loan to be supported by collateral security – i.e. you agree that if you aren’t able to repay the loan, the lender can take your business property to make up the difference.  There are two aspects to collateral for a loan: (i) underwriting, or how the lender values the business assets you have to backstop your commitment to repay the loan; and (ii) perfection, or the legal instruments required to document the lender’s claim on your assets.

Underwriting.  Among other considerations, the lender will be focused on the value of your business assets in comparison to the amount of the loan you’re seeking.  Generally, lenders will require the value of collateral to substantially exceed the amount of the loan – sometimes by a factor of 2x or more. Keep in mind: typically, each business asset can serve as collateral for one loan only, so by entering into a commercial loan, you may be implicitly agreeing not to enter into any other business loan (e.g. a business credit card or private financing from friends and family).

Perfection.  When you agree to offer your business assets as collateral for a loan, the lender makes a record in a public database – think about it like an engagement ring for your assets, a sign so other lenders will know they’ve already been claimed.  This process, called perfection, is highly technical and varies by asset type: real estate is different from inventory is different from patents. The more diverse your business assets, and the more complex your corporate structure, the more cumbersome – and expensive – this process can be.

Budgeting

After getting your loan amount approved, negotiating the term sheet, and following through with the loan documentation, budgeting for your loan disbursement may seem like a trivial task – but it isn’t.  Nor is it purely a mathematics exercise. Make sure you’ve adequately accounted for all upfront fees, expenses, reserves, payoffs, and other holdbacks required. We advise conducting this exercise when approaching lenders; after negotiating a term sheet; and again prior to closing the loan to ensure the loan amount will meet your business’s needs.

Transaction costs.  Although predictable, costs associated with undertaking the loan can be surprising if not planned for accordingly.  Typical expenses disbursed directly to third parties when the loan is funded include (a) fee for the lender’s counsel (ask for an estimate during the term sheet negotiation); (b) the lender’s origination fee (usually a % of the loan amount); (c) appraisal or other third-party costs; and/or (d) an interest rate hedging instrument (for some floating rate loans).

Other holdbacks.  In addition to transaction costs, expect there to be other line items that reduce the amount of your potential borrowings – or that may even require out-of-pocket cash payment.  At the term sheet phase, it’s not unusual for the lender to require a substantial deposit – to demonstrate that your business has liquidity, and to ensure you’re committed to the process.  Some other common examples: disbursement to existing lenders to payoff outstanding debts; a minimum deposit that must be maintained; or funding of a reserve account.

This article was written by Dac Cannon, who is an attorney with CLARK.LAW.  Dac holds BA, JD, and MBA degrees from UNC-Chapel Hill, where he was a Morehead Scholar.  In addition to assisting CLARK.LAW clients with a wide range of business deals, Dac also advises real estate and business owners in capital raising and disposition transactions.  Dac will be assisting the firm with a range of business matters. He can be reached at dac@clark.law.