Securities Law Blog

Access to capital is critical to every business. Entering into loan arrangements with a lender is a complex process, the results of which can be vital to the success or failure of a company. This is the first in a series of articles intended to explain various aspects of the loan process.

Almost all loan agreements begin with the parties negotiating a term sheet, which sets forth, the key terms of the transaction. Although most of the provisions in a term sheet are typically non-binding and many details may be omitted awaiting the final documentation, it is critical for the borrower to negotiate the provisions of the loan agreement at this early stage as the term sheet will be the blueprint upon which the loan documents are drafted, which documents will play a large role in dictating how the borrower will be able to operate its business during the term of the loan. Some lenders require the approval of a special committee, often referred to as a credit committee, to approve a loan. Accordingly, while the term sheet largely focuses on business terms rather than legal issues, it is highly recommended to involve legal counsel at the term sheet stage in order to protect the borrower from agreeing to terms that will flow into the final loan documents.

The term sheet stage likely provides the borrower with the strongest opportunity to negotiate the terms of the transaction.  The borrower is not committed to the lender until the term sheet or accompanying engagement letter is executed, and thus, the lender is more likely to have some flexibility at this early stage as it tries to lock in the deal. As the lender often receives credit approval based on the term sheet, it may be difficult to re-negotiate any of the provisions that are agreed to in the term sheet and any material changes during the drafting process may need to be sent back to the credit committee, which may reject such revisions.  Moreoever, loan documents are generally prepared using the lender’s form of documents and the negotiated term sheet.

Beyond the key financial terms, the following are a few important areas to consider when negotiating the term sheet:

• Identity of borrowers and guarantors – The lender may expect that the owner or parent company of the intended borrower will serve as guarantors of the obligations under the loan or that the borrower’s subsidiaries will provide a similar guaranty. To the extent that the borrower seeks to limit the parties to be included in the credit facility, this is the time to make clear which entities will be participating and the extent of their obligations.
• Collateral – If the loan is going to be secured, the borrower needs to make clear which assets it is willing to include as collateral. If the borrower has an expectation that certain collateral will be sold during the term of the loan outside of the normal course of business or that it will seek to borrow from another source using certain assets as collateral, such as entering into a factoring arrangement with respect to certain receivables, then such expectation should be communicated at this early stage to avoid any confusion and so that the loan documents may be drafted so as to permit such other transactions.
• Prepayment – It is important for the borrower to understand under what circumstances prepayment may be required, such as asset sales outside of the ordinary course of business, receipt of insurance proceeds or the issuance of equity interests. In addition, the borrower should clarify whether voluntary prepayment is permitted and, if so, whether there is a prepayment fee and if such prepaid funds may be re-borrowed.
• Reporting requirements – Lenders will typically require the delivery of financial statements, along with other reporting requirements. Often, this is not set forth in detail in the term sheet and simply refers to “customary reporting requirements.” To the extent any detailed requirements are included in the term sheet, the borrower needs to ensure that it is able to deliver the requested information without unnecessary cost or burden. Particularly with respect to financial information, the borrower should attempt to limit the reporting requirement to reports that it is already preparing.
• Covenants – These are the things that the borrower agrees to do or not to do during the term of the loan. Although usually set forth in the term sheet as a non-exhaustive list in summary form to be included in the loan agreement without much specificity or detail, the borrower needs to be cognizant of any items that are listed that would create an undue burden or would restrict the borrower from operating its business or pursuing other planned activities. With respect to any financial covenants, borrowers are advised to consult with their financial advisor and accountant to confirm the company’s expected ability to comply with any such requirements.
• Conditions precedent – These are the conditions that need to be satisfied before the lender will make the loan. Particularly under circumstances where the borrower is dependent on the proceeds of the loan in order to complete a transaction or to pay off a maturing loan, it is imperative that the borrower understand these conditions and be confident that they can be met within the required timeline. The term sheet stage is also the time for the borrower to raise any issues that may be material to the lender if discovered in the course of its due diligence, such as pending litigation or regulatory proceedings. It is not in the borrower’s interest for the lender to run into surprises as part of its due diligence process. It is better for all parties to be able to incorporate treatment of any such matters into the initial draft of the loan documents.
• Fees and expenses – Although most terms in the term sheet will be non-binding, the borrower will likely be required to reimburse the lender for certain fees and expenses involved with the lender’s due diligence and the preparation and negotiation of loan documents. The borrower needs to confirm when such amounts are required to be paid and whether or not any such amounts are refundable. Depending on the bargaining power of the borrower, the borrower may be able to negotiate a cap on any such expenses, or, if the lender will not agree to a cap, to agree on notification when expenses reach a designated threshold so as to avoid surprises at closing and to enable the borrower to work with the lender to rein in expenses before they become excessive. The borrower should try to avoid paying any commitment fee until the funding of the loan, or, if this is not possible, ensure that such fee is refundable in the event the loan does not close for a reason other than the borrower’s willful misconduct.
• Exclusivity – Lenders will often seek a period of time, typically from 30 to 90 days, when the borrower agrees to negotiate exclusively with the lender in exchange for the time that the lender will be committing to complete its due diligence on the borrower and to prepare and negotiate loan documents. It is in the borrower’s interest to limit this exclusivity period so that it has the ability to pursue other options should a favorable deal not be forthcoming with the current lender.

Negotiating the term sheet can be difficult, but it is essential to ensuring a successful transaction. This is the time when the borrower has the greatest negotiating power. It is critical for the borrower to obtain clarity in the term sheet for important issues so that it can effectively perform during the term of the loan.