Loan Agreement: Did You Actually Reach An Agreement?

IEquity: A Cheaper form of Finance

belong to the school of thought that, equity is a cheaper form of finance than debt. This might be because of Polonius' advice which goes, “neither a borrower nor a lender be”. I am therefore, of the view that small businesses should be careful when taking loans, or better, should not take loans in their first few years of operation, where feasible. This piece is not intended to argue for or against debt capital, but seeks to help entrepreneurs make informed decisions when borrowing. On debt finance, I find the words of Geoffrey Fuller in his book “Corporate Borrowing Law and Practice” instructive. The author states that “in the case of companies, borrowing, whether by loans from banks or by the issue of debt securities, is an essential feature of responsible financial management: too little and the company does not have as much money available for capital investment and working capital as it ought; too much, and the interest burden will cause financial problems”.

Caution in Taking Loans

Loans are a form of debt finance, but not all types of debts constitute loans. It is not uncommon to find a business owner being offered a loan facility by an account officer or relationship manager, who having perused the bank statements, sees that the company records a high turnover. In the event that you are approached with an offer for a loan, you may want to think about the timing, and your ability to repay. This is because, the banker-customer relationship is usually smooth, until a default is recorded. This statement brings to mind the image of a middle aged bank customer, who was raining invectives at the bank representatives and their Counsel, after judgement was given against him. The judgement of the court, was to the effect that the bank had a right to exercise the power of sale over the debtor's mortgaged property. Incidentally, the property in question, was the house in which the man and his family resided. As sorry as the situation was, the law had to take its course. It cannot be over- emphasised that, the obligation to repay is an essential characteristic of a loan.

I once met an entrepreneur, who was of the view that borrowing was a sign of business success. He said that the most successful businessmen in the world, were exposed to their banks. This may be true to a large extent, but it must be mentioned that businesses differ in their financial needs, turnover and asset structure. I dare say that the word, ‘gearing' was coined, bearing in mind the various commercial considerations to be taken by a business when raising finance. A responsible business is expected to maintain an efficient gearing ratio. This is the ratio of medium–term debt and long-term debt (debt with over one year's maturity); to shareholders' funds.

Avoid Desperation

In the event that a business is ripe for a loan, the representative of the company interacting with the bank on its behalf, must not be unduly desperate for finance. It is advisable that, a consultant is contacted to review the terms and conditions of the loan documentation, to avoid a situation whereby the debtor practically sells his life and that of his organisation. For better understanding, a loan contract or agreement, is a legally binding agreement between the lender and the borrower, which outlines the loan process and the conditions for grant of the facility. These documents which must comply with general and industry specific regulations, set out the duties and obligations of the parties, and seeks to protect them in the event of default.

It is most regrettable that, loan agreements and offer letters, are more often than not, skewed towards the interest of the financial institutions, to the detriment of businesses, and the economy, in the long run. It is equally unfortunate that, desperation for capital, whether debt or equity, renders many entrepreneurs handicapped in negotiation. A business owner should not limit his negotiation skills to marketing products or services, because managing a successful business requires the promoter to negotiate with clients, creditors, suppliers and other business partners. Understanding the loan agreement provisions, will help you identify your responsibilities and possibly the levels of risks you assume, by ac- cepting the commercial loan terms offered. It is one thing to read the loan agreement, and another to understand it. Many are not aware that, some terms are considered standard and which the lender is unlikely to negotiate, while others are unique to the particular lender or transaction.

Things to Look Out For

For instance, when requesting a long term loan, the borrower should be mindful of the lender's rate of interest. The interest fluctuation clause, might have been couched in a manner that authorises the lender to review the interest rate without the approval of the borrower. Further, the borrower must be sure to understand what the lender defines as ‘default'. It could mean failure to pay back the loan, or when the borrower is charged for an offence in court. Attention should also be given to ‘cross-defaults', when a default under an agreement triggers a default in another agreement; as well as provisions stating that non-payment of interest or capital automatically triggers a default.

A borrower should ensure that, the funds are utilised for the intended purpose, to make it easier for him to repay the loan before the due date. A facility granted for the purpose of importation of raw materials, should not be diverted to buying state of the art cars for the Founding Chief Executive and his family. It is not unheard of, that certain clauses are inserted to restrict the borrower from carrying out some activities during the duration of the loan agreement. notwithstanding, the borrower must ensure that he does not lose his flexibility in engaging in business, without breaching such undertakings.

Maintaining a specific positive cash flow level or debt-to-cash-flow ratio, may also be a required condition. Covenants that mandate operating activity, reporting and disclosure and preservation of debt priority, should be understood, because when violated, even inadvertently, the borrower may be required to undertake a specified series of actions, to maintain the banking relationship. If you negotiated or were assured of any specific terms or conditions, you should confirm that those agreed terms or conditions are captured in the agreement, before signing.

Generally, representations and warranties are included in loan agreements, to verify that the borrower is legally capable of entering into a financial contract. However, the borrower must ensure that the representations and warranties, only apply for the period when monies are owed to the lender, and not beyond that. Refinancing and amendments, should be carried out by mutual agreement. It is a red flag item to find an amendment clause, couched in such a way that gives the lender the authority to amend some clauses in the loan agreement, without the consent of the borrower.

Conclusion

Receiving a loan agreement after sourcing for debt finance from various sources, may seem like a great relief. It is however, at this moment, that a commercial borrower should slow down, and conduct a detailed review of the relevant documents. The legal terms are as important as the figures. A business owner who finds it hard to interprete these terms, is advised to hire consultants for this purpose. I am of the view that, a thorough understanding of the implications of taking a loan, altruism on the part of both parties, and a careful review of the relevant agreement, would reduce instances of dispute. Where such disputes arise, however, it is the duty of the courts at all levels, to exhibit a balanced approach to resolving same.

“IT IS MOST REGRETTABLE THAT, LOAN AGREEMENTS AND OFFER LETTERS, ARE MORE OFTEN THAN NOT, SKEWED TOWARDS THE INTEREST OF THE FINANCIAL INSTITUTIONS, TO THE DETRIMENT OF BUSINESSES, AND THE ECONOMY, IN THE LONG RUN”