JUNE 2013 NEWSLETTER

HOW TO NEGOTIATE COMMERCIAL LOAN DOCUMENTS

In the current financial environment after the recent booms and recessions of the late 1990’s and 2000’s, and in light of new financial regulations it can be difficult to obtain commercial loans. The following article discusses steps that can be taken to make it easier to obtain commercial and real estate financing. This involves the proper preparation, identifying the proper lending institutions, and identifying the terms that can and should be negotiated.

Types of Debt:

A borrower needs to determine what type and amount of debt it needs. There are a number of debt instruments, but the two most common are lines of credit and term loans. A line of credit is a credit arrangement in which a financial institution agrees to lend money to a business on demand up to a specified amount. A term Loan is a loan for a fixed amount that has a specified repayment schedule and a fixed or floating interest rate. Term loans almost always mature between three and ten years with a balloon principal payment.

Lines of credit provide the flexibility to draw at any time to cover fluctuating needs such as day to day working capital. The borrower can decide how much principal to pay off or increase the amount borrowed without bank intervention. The maximum borrowing base (maximum amount that can be borrowed) is normally based off of a percentage of current accounts receivable and inventory. Term loans are less flexible but allow for more stability with fixed payments throughout the term. Term Loans are usually used for long term financing for purchases or new ventures. The amounts are usually based off of the value of the collateral and/or the future cash flow of the business.

A borrower must determine which loan it desires and how much. If it is looking for stable payments to purchase property, capital improvements, machinery, or to purchase an existing business, usually a term loan is desired. If it is looking for flexibility to cover basic expenses, payrolls, or to cover working capital expenses then a line is usually desired. Most businesses combine a line of credit with a term loan.

Preparing for Negotiating:

Next, the borrower must prepare the following paperwork in anticipation of approaching banks to convince that it is a good loan candidate. Lending institutions are essentially looking for evidence of the ability to repay a loan, the promises of future business and the growth of the business.

Lending institutions will want financial documents indicative of past performance and current net worth. Businesses will need to provide a full set of financial statements whereas individual borrowers/guarantors need to provide personal financial statements. With these, lenders require tax returns with backup documentation/verification to help verify such amounts. This shows a borrower’s past profitability and asset pool that can be used to satisfy the loan payments.

Lending institutions will also look for documents projecting future ability to pay. For long term stable businesses or rental real estate with a history, this may simply be the prior three year’s income statements as they can reliably project future income from the past income. For new/less stable businesses, this requires proformas projecting future cash flows along with a description of assumptions and sensitivity analysis to show robustness with different assumptions. Many lenders have specific rules they look to meet such as the cash flow must cover 1.3x of payments, or the loan to value ratio cannot be greater than 70%.

Last, a borrower should prepare any other documents that a bank may ask for and anticipate troublesome inquiries. A lender may want to review leases, permits and environmental reports after an initial review of the statements and future projections to verify the ability to operate the business. Further, a borrower should address any anticipated questions. If a borrower has a recent poor performance trend, a borrower should prepare what measures have been taken to reverse such recent trend.

Where to Obtain the Loan?

Different banks have different lending profiles so it is best to shop around. One bank may have an expertise in servicing business or commercial real estate loans versus consumer real estate loans while another may not want to touch one or the other. Further, different banks may have different administrative rules in terms of charging points, lending limitations, administrative fees, and audits. Some may also have reputations that precede them both positively or negatively in dealing with borrowers. It is important to shop and research to find the appropriate bank.

Additionally, if larger amounts are required than local banks can risk, it may be desirable to explore other types of financial institutions such as insurance companies or investment banks. Insurance companies may have more flexibility to negotiate specific terms (discussed below) than a rigid local bank. Also, if substantial funds are necessary, an investment bank or private 5 equity firm may be the only options, but this may require surrendering some management control or equity interest to the private equity firm.

It is important that the borrower match its needs to the proper financial institution that usually services such needs.

Terms that Can be Negotiated:

After narrowing the banks down to one or two, there are a number of terms that should be negotiated. It may be favorable to be flexible on less important terms to receive better terms in other areas. Below discusses a non-exhaustive list of different terms that should be negotiated.

Loan Origination Fees:

Loan origination fees may include a direct payment to the bank for indirect additional profits and to cover bank expenses, the bank’s legal fees for drafting the lending agreements, the additional costs of appraisals, and other relevant closing fees and costs. Many times banks will reduce these fees for business or use alternative or in house attorneys or appraisers to lower legal fees and appraisal costs. Sometimes banks make these fees higher than necessary hoping to make an extra profit if the borrower will not ask.

Interest Rates:

Interest rates can be negotiated down or higher interest may entice a bank to add certain other desired features. A bank might start with 6% interest, but when pushed may offer a one year fixed rate of 4.5% for a new customer. Also, if a borrower desires higher borrowing base off of its collateralized assets, an extra .25% or .5% of interest may allow this.

Loan Origination Fees vs. Interest Rates:

A borrower needs to balance loan origination fees versus the interest rate. Sometimes, a higher origination fee can obtain lower interest rates. For example, 2 points on a $1,000,000 loan would be $20,000. However, the points may allow a lower interest rate which will save $50,000 (accounting for the time value of money) over the two year life of the loan leading to a net $30,000 in savings. Thus, the different point vs. interest rate options should be analyzed.

Collateral Limits:

If borrowing off of real estate, accounts receivable or inventory, banks may give a lower valuation of the underlying asset or place low borrowing limits on such value. For instance, a bank may initially offer a line of 45% of the inventory value and the bank values inventory at 80% of its fair market value by characterizing certain inventory as obsolete etc. It is important for the borrower to recognize these issues and attempt to negotiate with the bank to value the inventory at its full market value with a line up to 60% of inventory nearly doubling the effective 6 borrowing base.

Longer Amortization Periods:

A goal of all borrowers should be to analyze and obtain the right payment amount for the principal portion of any term loan. If the loan term is shorter than the amortization period, a balloon principal payment will be due at the end of the loan term. However, based on the cash flow of the business, it may be in the best interest of the borrower to obtain a longer amortization period and a lower monthly installment payment.

Prepayment Penalties:

Many banks charge a percentage fee for early principal payments. These may be from 2% to 4%. This will be incurred in a refinancing situation. A borrower can ask for no or lower fees or could ask for an option to refinance after 3 years without any fees or a decreasing prepayment or cancellation fee over a 2 to 5 year period.

Limiting Guarantees:

A business owner may be asked to provide unlimited personal guarantees for a loan so that the bank may seize personal assets in the event of default. However, if the borrower can demonstrate sufficient profitability, post sufficient collateral, or provide the bank other business, it may be able to reduce the guarantee to a fixed dollar amount, a fall back guarantee, or no guarantee at all.

Notice to Cure Defaults and Less Stringent Loan Covenants:

Loan covenants are one very important area to negotiate as this is what normally determines an event of default even if 100% of payments have been made. A bank may be able to call a loan if the current ratio (current assets/current liabilities) drops below 1.4 or if the loan to value goes above 80% of the collateral. Banks may even place subjective “catch all” terms that a bank may call a loan at its discretion if it feels the security of the loan has been impugned. This gives a bank a license to call the loan at any time and may be used as a pretext to receive extra fees or higher interest rates. It is best to understand and negotiate less stringent and/or realistic covenants and remove such subjective conditions to avoid being sideswiped by an event of default even with a perfect payment history.

At the very least, the borrower should negotiate an ability to cure any covenant defaults which is typically thirty (30) days.

Additionally, a borrower can request a bank to take seasonality of a business into account. The bank could have less stringent offseason breaching covenants for 2 to 3 months out of any 12 month period so a borrower is not punished for the seasonal nature of the business.

Conclusion:

In the current economy with added regulations and bank red tape it can be difficult to find proper financing. However, if a borrower makes the proper preparations and presentation, shops around, and negotiates on specific terms, a business may be able to find a diamond of a loan in the rough.