Oftentimes companies do not pay attention to the loan agreement and sign it off as standard template of the bank. The banks in turn do their bit in convincing management, and particularly younger entrepreneurs that such is the case and that everybody signs the same document.
Nothing could be further from truth.
Remember: A bank’s job is to protect its own interest and earn a commission or interest charge on the money which it extends to you. Period! Do not let friendly commercials make you feel any other way. Banks are not interested in helping you set or scale up your business. That’s squarely your job.
Reviewing the broad terms of the loan agreement
Most people pay all due attention to the broad terms of the loan agreement, including:
- The term and tenure;
- Security for loan or charge;
- Interest rate;
- The terms of repayment.
Very few look at the fine print that follows. While a lot of the clauses are boilerplate, within that, a lot could be negotiated and possibly struck off depending on your business and future plans. Your best chance of doing this is naturally before signing the agreement when you have some negotiating power with the bank.
Negative covenants – Negotiating beyond the broad terms
A negative covenant is an undertaking given by the borrower to the bank that the borrower shall not do certain things without prior consent of the bank. In most loan agreements, these terms are standard and appear towards the end.
Common Negative Covenants for Corporate Loans
In a typical corporate loan, you will find the below negative covenants:
The company shall not undertake any of the following activities without obtaining prior consent from the bank:
- Issue any debentures, raise any further loans, accept deposits from public, issue equity or preference capital, change capital structure, create charge on its assets or give any guarantees (unless for normal trade guarantees or in ordinary course of business);
- Undertake any new project or venture, modernization and expansion of existing projects;
- Enterinto fresh selling and purchasing agreements;
- Prepay any debenture/ loans availed from any other party;
- Pay any commission to its promoters, managers, directors or other persons for furnishing any guarantees;
- Declare or pay any dividend to its shareholders during any financial year unless all dues to the bank have been cleared for the year;
- Create subsidiaries;
- Merge, consolidate, re-organise or compromise with its shareholders or creditors;
- Make any investments by way of deposits, loans, share capital in any concern;
- Revalue its assets;
- Carry on any trading activity;
- Sell, dispose of or create any mortgage, loan or charge on assets charged to the trustees;
- Utilize the proceeds of debentures for financing funds or acquiring securities of other group companies;
- Modify, amend or alter the project document or the power purchase agreement;
- Sell present, or future revenues or cash flows to be received or create any charge or encumbrance on them;
- Raise any new capital or create any charge on its assets;
- Remove any person exercising substantial powers of management;
- Not pay any commission to a person exercising substantial powers in a year where the bank has not been paid its dues for the years, nor pay any compensation for loss of office for such person for whatever reason in such year;
- Appointment or reappointment of persons who will exercise substantial powers.
Prepayment and Termination Clause
Loan agreements can be terminated with a prior notice from either party. Typically banks will have a prepayment clause in their loan agreements and will charge you a small percentage of the principal amount as a prepayment penalty. Chances are that in case of a pre payment of a loan, either things have gone very well or that you are planning to restructure the loan. Make sure that the pre-payment clause does not impose a penalty higher than 2-2.5% of the outstanding balance.
Why is it important to read the loan document in its entirety?
Before we even answer that, there are 2 things that need to be highlighted here:
I. First, for most part banks will not invoke any clause even if a business were in violation of one or more of these. This is particularly the case for large well established businesses. The reason is simple. Banks need these companies to extend loans to them far more than these companies need the banks (the fact that The State Bank of India has still not liquidated any assets of Kingfisher Airlines is a proof to this). Think about it, which corporate would like to open a credit facility with a bank which has previously sold of the assets of a client or forced a client to file for bankruptcy?
II. Second, when it comes to smaller or midsized businesses, a bank may not act the same way. Small and midsized businesses are not the regular bread and butter clients of a bank. Further, the chances of a small business failing are a lot higher than a well established corporate, a fact that banks are well aware of, and hence they are less willing to give time to a smaller business.
As a young or midsized business (actually, even as a well established business), what you need is the flexibility and autonomy to carry on and scale up the way you want. Imagine having to deal with a situation where you need to convince a bank about the merits of getting new partners into your business, or of merging with or acquiring a business?
What a company should be doing is analyze carefully its future plans and negotiating terms on that basis. Oftentimes, bad terms in a loan agreement can prove fatal for a business when things do not go as planned.
If you want to get your agreements drafted or reviewed you can get in touch with the author of this post @ [email protected]