What should you look for when making a private loan to a business?
It’s very important that you understand the standard commitments a business borrower should be making to you… and that they are part of your loan documentation!
A Summary of Terms (often called a Term Sheet) like the one described below, should be created and agreed to before you privately lend to a business. This document is the simplest way for each of the lender and borrower to understand the deal they are making, and the Term Sheet will be the basis upon which the other closing documents are drafted. We strongly encourage you to use early on legal counsel specializing in private finance when negotiating a Term Sheet.
SUMMARY OF TERMS
$ Loan Amount
Basic loan terms - Interest rate, security description (Senior Secured, Mezzanine, Junior Note, Convertible Note, etc.) and Maturity Date
|Loan Summary & Purpose:||Describes form of lending and the Borrower’s use for the loan proceeds they receive. The debt can be structured as a loan or note that is secured or unsecured, senior or subordinated, etc. See “Forms of Lending” for more information.|
|Borrower:||The legal name and location of the obligor for the indebtedness. It is very important that this be very specific and absolutely accurate in terms the legal description of the Borrower.|
|Investor(s):||The lenders name or, for a syndicated loan or note offering the type of investors being offered participation (e.g., Accredited Investors).|
|Loan Amount:||This will define the amount the Borrower is seeking to raise. It may indicate a minimum amount, but it will always indicate a maximum.|
|Interest Rate:||An annual Interest Rate or Coupon will be specified such as “6% per annum, payable on the outstanding balance”. It should specify how often interest is to be paid (typically monthly or quarterly) and how each payment is to be calculated (ex. Annual interest rate times actual days elapsed /365 days). Note: if a note “amortizes,” that means the Principal is being paid over time versus at maturity. The interest amount paid to lenders will reduce proportionate to the reducing principal balance.|
|Maturity:||The date when all the note’s outstanding Principal is due (the Maturity Date).|
|Amortization:||The Loan payments may be structured with amortization over the term of the loan wherein a partial payment of principal is paid with each interest payment. Amortizing loans are typically either mortgage style involving a fixed monthly payment that includes both interest and a partial principal repayment or level debt where the principal component of the payment is fixed, and the interest component reduces based upon the declining principal balance. If there is no amortization, all the principal will be due and payable upon the Maturity Date, otherwise known as a bullet maturity.|
|Prepayment Option:||Optional prepayment (all or partial) of principal by the borrower is an accommodation by the lender to the borrower. It gives the borrower the option to either reduce their indebtedness before it is otherwise due to be paid or to refinance the debt from loans with other lenders offering a lower interest rate to the Borrower. If prepayment is agreed to by the lender, it may be stipulated that the Lender must have received a minimum Cash-on-Cash Return on their loan investment before a prepayment option is available to the Borrower.|
|Guarantees:||In private lending, the owner of the borrower is often required to guarantee the loan interest and principal payments being made by their company. Even if the financial strength of the owner is not sufficient to pay the loan amounts, a guarantee provides comfort to lenders that the owner is fully committed to the loan’s payment as it ties the owner’s personal financial welfare to the business’ loan payment performance. Third parties can also be used as guarantors if the owner is not strong financially.|
|Seniority:||Describes the position of the loan relative to other borrowings of the Borrower. IMPORTANTLY, not all loans are equal in terms of their credit strength. The liquidation priority position of a loan within the capital stack of a Company is extremely important in the event of bankruptcy. The more senior the loan (see illustration below) the more control and higher priority the loan has when the credit obligations of the Borrower are being paid from the proceeds generated through asset liquidation.|
|Collateral:||If specific assets of the Borrower secure the loan, it is collateralized, and collateral offers lenders an alternative source of repayment. If the loan’s collateral in a first lien position which has been properly filed with a state (also known as a UCC) the lender has a first perfected security interest in the specific collateral supporting the loan’s repayment. Typical Collateral include accounts receivable, inventory, property, plant and equipment (PP&E), cash and other assets and it is very important that an independent lien search be conducted for all collateral offered to support the loan.
An advance rate will be specified against the collateral’s ongoing market value that limits the loan’s acceptable principal balance. If the market value drops, the Borrower must either provide additional collateral or pay down the loan’s principal balance to an acceptable level. The value of the Collateral must be monitored and verified on an ongoing basis be the lender or their representative to ensure that it remains within the advance rate guidelines.
Lenders should be secured by everything of value which the borrower can offer. Borrowers will want to offer as little as possible, as they may need to use assets to support additional debt.
|Reps and Warranties:||Representations and affirmations made by the Borrowers, including but not limited to: accuracy of financial statements; no material adverse change; absence of litigation; no violation of agreements; compliance with laws; payment of taxes; solvency; compliance with environmental matters; accuracy of information; and validity, priority and perfection of security interest in the Collateral.|
|Conditions Precedent to Initial Funding:||Including but not limited to satisfaction with all legal and financial due diligence relating to the Borrowers.|
|Affirmative Covenants:||Borrower commitments including but not limited to performance of obligations; delivery of agreed financial information and compliance certificates; notices of default and litigation; maintenance of satisfactory insurance; compliance with laws, regulations and payment of taxes.|
|Negative Covenants:||Limitations to the Borrower’s activities may include (1) a cap on the amount of indebtedness undertaken by the Borrower debt; (2) a cap equipment or capital leases for equipment; (3) maintenance of an interest payment reserve; (4) distributions to equity holders; (5) prohibition on loans to Members; and (6) other business activity and financial restrictions specific to the borrower and that are reasonable protections for the Lenders.|
|Events of Default:||Usually includes to non-payment of principal and interest (subject to a 10 day grace period for payments of interest with a subsequent 30 day cure period, provided that if cured, original terms and conditions of remaining Notes outstanding shall revert to those existing at time of original issuance), violation of agreed covenants, incorrectness of reps and warranties, cross default and cross acceleration, bankruptcy, material judgments, and invalidity of guarantees, and change in ownership.|
|Investor Approval:||Establishes a threshold approval amount, typically a majority or super-majority vote by Lenders based upon the amount of Loan principal. Votes are taken to modify the Loan terms and for other releases by the Lenders from Borrower covenant restrictions.|
|Default Rate:||If the lender doesn’t pay the interest when due, or another Event of Default occurs, the note will usually carry a Penalty Rate, or Default Rate, that is applied on both the Principal and outstanding interest until the default has been remedied or cured (fixed). CFG typically applies a 5% Default Rate if there is a default by the Borrower.|
|Escrow Account:||If a minimum amount of funding is needed to achieve the stated goals of the borrower, an Escrow Account may be used for loans syndicated among multiple lenders.
In such cases a minimum amount is identified before any funds are released to the Borrower, with the Escrow account established at a bank providing escrow services. This bank will be the Escrow Agent for the loan. Until the minimum amount has been raised, Investors’ funds will be held in safekeeping before being released to the Borrower. If the minimum has not been raised before by the end of the offering period, funds held in Escrow are returned to Investors. The Borrower will often pay Investors a rate of return during the period their funds sit in the Escrow account but are never released to the Issuer.
If a minimum amount of funding is not important, loans may be structured using a Continuous Close process without channeling funds through an escrow account.
|Placement Agent:||While some Borrowers raise the capital themselves, others hire Placement Agents to raise larger amounts of capital, such as Carofin’s broker-dealer, Carolina Financial Securities, LLC.|
|Administrative Agent:||Once the capital raise is complete, the work has just begun. Administrative Agents, if used, perform many roles supporting lenders, including:
Continuing to represent Lenders with the Borrower;
Overseeing the Borrower’s compliance with the loan covenants;
Processing interest and Principal payments from the Borrower to the Investors;
Preparing and paying all Regulation D filings and other actions required in the administration of the Loan on behalf of the Investors.
CFG Financial Services, LLC, which is 100% owned by CFG, acts as administrative agent on most Offerings.
|Fees and Expenses:||Placement fee: Ordinarily, this is calculated as a percentage of the funds being raised and is paid by the borrowers from the funds being advanced to them.
Borrowers will also reimburse the Placement Agent for any Offering expenses, which will include out-of-pocket due diligence expenses, legal, travel, and other expenses related to the Offering.
|Targeted Closing:||Often a Term Sheet will indicate a targeted first closing date after which ongoing closings may occur on a continuous basis.|
The Summary of Terms defines the offer for Investors / lenders. It forms the initial information that a potential Investor is likely to receive. Once an Investor has indicated interest in the Offering, and the Closing Documents have been crafted, these will be forwarded to subscribe to the Offering.