Sweat the details in your loan commitment letter
As the economy in West Michigan continues to improve, we are seeing more companies adding new equipment, expanding their office or manufacturing footprints, investing in new technology and welcoming new employees.
All of these are welcome signs of growth — and often require capital beyond what a business may have on hand. That means a trip to your bank to negotiate a loan. And that means working through a loan commitment letter, one of the most important steps in the process of securing financing.
The process may begin with a term sheet, which spells out the parties to the transaction, how the loan will be structured, terms of the loan and other critical details. It is nonbinding, though, and gives the lender the opportunity to decline the loan after its due diligence.
That’s where the commercial loan commitment letter comes in. A binding document, it solidifies all the details of the loan, spelling out everything from interest rates to covenants.
Top areas of focus
Both sides of the transaction should pay close attention to the negotiations around the loan commitment letter to ensure a successful transaction, especially:
Loan amount: Banks typically lend between 60 and 80 percent of the appraised value of underlying assets, which is guided by the loan-to-value ratio, along with other metrics, such as debt service coverage. Businesses with strong track records and high net worth are often able to call for greater loan-to-value percentages.
Interest rate and amortization: Interest rates can either be variable or fixed. Variable interest rates are generally pegged to the London Interbank Offered Rate (LIBOR), interest rate, prime interest rate or treasury yield curve interest rate. In addition, interest might be compounded on a simple or compounding basis. A borrower should be sure to specifically state how the interest is calculated. The determination of the period over which the principal is decreased, or amortization of the loan payments, should also be understood. The longer the amortization period, the less the principal gets paid down over time.
Fees and expenses: Be sure to have a description of any fees and their due dates. Fees might also be conditional or be refundable.
Prepayment: Some loans allow a borrower to prepay at any time, while others do not permit prepayment before a specified date. In addition, many loans allow for prepayment at a cost. Paying special attention to prepayment provisions could prove valuable should an opportunity to sell an asset or refinance the debt at a better rate present itself during the loan period.
Guaranty: A guaranty can take several forms. Some guaranties are limited to a specific dollar amount; others are limited to certain durations. Guaranties might also be partially or fully released as the loan-to-value of the financed asset decreases, the loan is repaid or particular financial covenants are achieved.
Recourse and bad-boy provisions: Consider if the loan is a recourse loan, meaning that the bank has the choice to sue on the note and collect directly against the borrower. A non-recourse loan allows the bank to merely foreclose and seize the attached collateral. Some commercial real estate financings take the non-recourse form yet will have certain carve-outs outlined in “bad-boy” provisions such as, for example, fraud.
Covenants: Financial covenants almost always appear in commitment letters. A covenant might require that the borrower maintain a certain debt service coverage ratio or a net worth covenant that would require the borrower to maintain a certain value throughout the loan’s life. It is essential to clearly define such covenants, as a failure to maintain such covenants constitutes a default.
Change of control: Like covenants, restrictions on changes in control might bind a business and might also impact estate planning. Banks often demand that there are no transfers of equity interests in the borrower during the loan period. A borrower might seek provisions that would allow them to convey ownership interests where such conveyances do not amount to a change in control.
Escrow of funds: Banks might require that a borrower escrow funds to assure certain payments are made, such as tax, insurance payments or maintenance costs. The escrow account is often funded with a lump sum due at closing, or with the monthly payments of principal and interest.
Rob M. Davies, partner at Warner Norcross & Judd LLP, concentrates his practice as borrower and lender counsel in commercial finance transactions. He chairs the firm’s Commercial Finance Practice Group. He can be reached at firstname.lastname@example.org.