Start-up, scale-up or grown up, there may come a time when any business leader needs to consider taking a business loan. Whenever you’re borrowing, there are some do’s and don’ts that are useful to remember.
Do be prepared
As borrower, it’s helpful to be realistic about your borrowing requirements. The amount you need may not easily be available.
At the start of any discussion for a loan, a lender will be considering the credit risk of the deal and whether it can commercially make the loan available, at what cost to the borrower and under what terms.
There is a huge amount of due diligence that a lender will need do before handing out money to anyone, so it is wise to be upfront about all aspects of your business as any skeletons in the closet are more than likely to be flushed out during the due diligence process, credit checks, document negotiation and preparing and completing the conditions precedent.
Borrowers and lenders are subject to anti-money laundering and sanctions regimes in the UK and will need to take into account anti-corruption legislation. Be prepared to provide all identification and source of wealth information to a lender including relating to relevant persons.
Do understand the available types of financing
There are so many different types of loans and sources of financing available to borrowers.
Larger entities tend to have more complex financing arrangements and may require a variety or combination of loan facilities as part of one transaction from a syndicate (group) of lenders.
Smaller borrowers, and those that are newly formed, tend to require more straightforward financing from one lender (known as bilateral lending). However, the stages in any loan finance transaction are broadly the same whatever the complexity of the particular deal, and the main finance documents used are common to various types of financing arrangements.
Do you need a bridge loan? Long term loan? Short term loan? Overdraft or revolving facility? A lender should ensure a borrower is clear on what its needs are including any contingency funding to cover unexpected problems. Lenders and borrowers are aligned in not wanting a borrower to fail to repay its loan when due (known as a default)
Generally, an overdraft is often the best way of funding working capital as you pay interest only on the amount you are overdrawn each day. Exceeding an overdraft limit incurs charges and higher interest rates and may damage your credit rating. However, equally using an overdraft to finance long-term borrowings can be problematic and might leave you with no short-term finance available for working capital increases.
Don’t forget the costs to breaking a term
Fixed term loans (long term or short term loans) are fixed for a period i.e. one to ten years and are usually the most cost efficient way of financing equipment, property purchases, vehicles and long term borrowing requirements. But you should remember that if you have agreed to a fixed term, there will be consequences if you choose to pay back the loan early. This is because the lender will have costed the loan and determined the appropriate interest rate based on the amount of interest you will pay back over the agreed term. Breaking the loan during a fixed term is also likely to cost the lender additional costs as it is likely to have obtained finance from its own sources for the equivalent committed amount of time. Loan agreements will include provisions on “break costs” dealing with the costs of paying a fixed term loan back early.
Do read the term sheet
At the beginning of any loan financing transaction, the lender will typically prepare a term sheet setting out the high-level commercial terms. It’s important to read this carefully and get comfortable and clear about it before incurring the costs of preparing the finance documents – it is very unlikely a lender will move away from the agreed position in the term sheet on any important commercial matters when it comes to negotiating the loan agreement (also called a “facility agreement”). Ensure you are clear regarding:
- The amount of money you are borrowing
- When it needs to be repaid
- How it needs to be repaid – will repayments be monthly or after a fixed term
- The agreed method of repayment
- What are the consequences of late payment or non-payment and when the trigger for those consequences occurs
- The cost of the loan i.e. the interest, arrangement fees, lender’s legal costs etc
- Details of the security package required to protect the lender’s position
Don’t forget the Conditions Precedent
Once the term sheet and commercial terms of the loan are agreed, the finance documents will be prepared. The loan agreement will include the main terms (as mentioned earlier) and will include a list of documents and information that need to be provided before a loan can be made (drawn down). These conditions are required to ensure that the lender has the full picture of a business and all the relevant borrower-side parties (borrower, security providers, guarantors etc) before a loan is made available. The conditions precedent documents and information will need to be up to date, within the time frames as specified by the lender so there is no hiding behind out-of-date information.
The clearer the picture that the lender has, the more likelihood it will build in flexibility into the loan arrangements should things go wrong so it makes sense to be upfront about your business at the early stage of negotiating the loan.
Do understand the security required
Loans can be unsecured. But these tend to attract higher interest rates to reflect the risks the lender is taking. (Think of the high rates of peer-to-peer lending sites and/or credit cards).
A secured loan is where the money that was loaned is secured against an asset either belonging to the borrower or to a relevant third party. If the borrower fails to pay back the loan on time (a default), the asset can be recovered by the lender and potentially sold in order for the lender to recoup back some of the money it has loaned. There is usually no requirement on a lender to enforce any of the security or guarantees in a particular order. A lender will generally look for the path of least resistance and maximise the value of the assets available to it.
A secured loan means there is less risk for the lender. However, there are different forms of security which have different levels of impact on a borrower’s business. The lender may ask for:
- The directors of a company to personally guarantee the payment obligations of the company. The directors should be aware that this means they are essentially personally liable for the loan. Giving a guarantee can impact their own personal credit scores, may need consent from any other third parties from whom they have borrowed money or given other guarantees e.g. a landlord. Also, giving a personal guarantee to a lender of the company pierces the corporate veil financially and the lender can make a claim over the director’s personal assets if a director fails to make a payment demanded under a guarantee
- Debenture from the company – this is a wide-ranging security taken from the company over all its assets. Debentures cover all assets of a company and so the directors should ensure that they build in any flexibility they need from the ‘security net’ in order to be able to continue to use the assets of a company to do business. Does the debenture prohibit your company from using cash in your bank account? Does the debenture include restrictions on using IP or other rights? Does the debenture restrict disposals of stock?
- Mortgage over property – this is security taken over real estate. And gives the lender a proprietary interest in the property. If the property is sold, the lender would have a first right over any sale proceeds needed to repay the loan. Where a lender takes a mortgage over property, there will usually be a restriction entered into the title of the property notifying all third parties that the property cannot be sold without the consent of the lender. Borrowers often forget that this information will be available publicly if anyone searches the title of that property and will reveal that the property is secured to a particular lender.
- Legal charges over specific assets of the company – As mentioned earlier, directors of a company should ensure that the security over the asset allows flexibility for the business to use or have access to the asset and does not restrict the business operationally.
Do be realistic about the value of business assets
A lender will value assets conservatively where such assets are to be used as security – there will be recovery costs, devaluation if a business is failing, difficulties in collecting debts, resale prices, lack of markets where assets are being sold etc to take into account impacting the value of the asset at a time when the lender needs to sell it.
A lender will want to ensure a borrower has appropriate insurance cover in place for not just assets, but key man insurance for key employees against accident, sickness or death and the lender may wish to be noted on the policy or be co-insured or jointly insured. As a borrower, you’ll need to be clear on the cover in place and also whether the lender’s requirements can be complied with.
Don’t forget security needs to be registered
An important note is that any security granted by a UK registered company (the borrower or another third-party company security provider) will need to be registered at UK Companies House and will be available for any third party to see. Some confidential details such as the amount of the loan secured etc do not have to be disclosed but the name of the lender, type of security etc will be available publicly to anyone who searches that company on Companies House.
From a lender’s perspective, registering the security is non-negotiable. Without duly registered security (at Companies House or the Land Registry) the lender is deemed not to have given requisite notice to all third parties about its security interests and the security may be unenforceable against an insolvency practitioner and any creditor of the borrower, leading to the lender potentially being unsecured and falling down the priority list should the company enter into difficulties and begin insolvency proceedings.
Do understand the borrowing costs
- a) Interest rates are usually set at a margin over a bank base rate. The margin will depend on your risk profile, the loan and the lender’s policies. Alternatively, the interest rate on a loan may be fixed at a flat rate.
- b) An arrangement fee is usually payable when loan is set up. Typically, the fee is a percentage of the amount of the facility requested that is payable when the loan is paid out.
- c) There will be legal costs for drafting and negotiating the loan documents (loan agreement, security documents, guarantees and any other ancillary documents such as notices of assignment, legal opinions etc) – likely to be incurred by a lender but recouped from a borrower. Lenders and borrowers should therefore be clear what the legal costs are going to be at the outset and agree who will meet these costs.
- d) There is likely to be a drop-dead fee for any aborted loans where a lender has obtained investment committee approval and incurred time and costs should you decide against taking out the loan.
- e) You will be responsible for costs regarding the security including registrations as mentioned above.
Do get tax advice
There may be issues regarding withholding tax on payments of interest to the lender, deductibility of interest for the borrower and tax issues on the enforcement of security.
Do make sure your relationship is the right one
Commercial terms will generally be standard in line with the risk profile of the deal but the main area of control you have as a borrower is to get into bed with the right lender. Does the lender have knowledge and more importantly, flexibility to take into account the ebb and flow of your business? Your business may be seasonal or cyclical – can the lender accommodate your business model?
A lender and borrower should have regular updates on the financial position of the business and have any upfront discussions about any upcoming key events which might increase or decrease the borrower’s financing needs, ability to repay the loan or require flexibility from the security arrangements over its assets.
Whatever your situation, financing requires a good relationship between lender and borrower, one that will hopefully last long beyond the term of the loan. A borrower needs someone to work with it if things get difficult and different lenders will have vastly different risk appetites, obligations and processes and procedures dictating how much flexibility they can give to a borrower in difficulty. A good relationship means that a lender will be there for any other financing needs of the business as the business grows.
Written Stephanie Donaldson
Principal at My Inhouse Lawyer
One of our values (Growth) is, in many ways, all about cultivating a growth mindset. We are passionate about learning, improving and evolving. We learn from each other, use the best know-how tools in the market and constantly look for ways to simplify. Lawskool is our way of sharing with you. It isn’t intended to be legal advice, rather to enlighten you to make smart business decisions day to day with the benefit of some of our insight. We hope you enjoy the experience. There are some really good ideas and tips coming from some of the best inhouse lawyers. Easy to read and practical. If there’s something you’d like us to write about or some feedback you wish to share, feel free to drop us a note. Equally, if it’s legal advice you’re after, then just give us a call on 0207 939 3959.
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