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Essential issues in loan agreements

Like equity, debt is an important component of the finances of any business. However, the market for lending to startups is quite small. Since their cash flows are unstable and the venture is fraught with risk, startups do not prefer debt in their early stages. However, many Indian banks are gradually starting to provide loans for Small and Medium Enterprises (SMEs) to benefit from lending to this segment of the market.

Lenders will agree to provide debt if the venture is less risky or they have some assurance that it will be able to service the debt (through interest and other repayments). Usually, lenders insist on security against the property of the company or the personal property of the founders while agreeing to provide a loan. In this part, we shall discuss some of the broad issues that arise while entering into a loan agreement.

While every agreement may have minor modifications, reliance on a standardized format helps in saving on costs incurred on negotiation of every minor detail (as the number of parties is high and individual interests of each lender could differ with respect to particular clauses). In the discussion below, we outline the key issues in loan agreements:
  1. Purpose of the loan
The purpose for which a loan is taken is extremely important – the terms of a long-term loan (e.g. for an infrastructure project) will be extremely different from those of a loan of a short term loan of, say 2 years.
Banks specify restrictions on the manner in which a borrower can use the loan amount (called end uses) – auditing powers of the banks and information covenants as per the documentation provide sufficient rights to monitor the utilization of the loan. Under law, one cannot obtain a loan from a bank for certain end-uses – e.g. for financing an acquisition of shares.[1] However, non-banking financial companies (NBFCs) can lend for such a purpose (subject to certain limits) (see below for a detailed discussion on NBFCs). Further, banks usually insist on more stringent security requirements (see below for a discussion of security), as compared to NBFCs. Hence, businesses may prefer to take certain kinds of loans from NBFCs for strategic and regulatory reasons.
  1. Costs
Interest rates and any other fees payable on the loan must be understood by the borrower. Often, banks may charge lower interest rates but compensate by charging various categories of fees, the financial impact which must be evaluated before taking the loan. Interest is payable at certain pre-determined dates (e.g. at the end of every quarter). The interest rate can be a fixed rate (e.g. 12.5 percent), or variable (called floating interest rates) – more frequently they are floating. A floating interest rate is pegged to a particular reference rate, such as the base rate of the RBI (or the London Interbank Offered Rate or LIBOR in case of ECB), plus a certain amount of margin called the ‘spread’.

In syndicated loans, the arranger bank, that is, the bank which plays a critical role in bringing together the other participating banks as lenders in the transaction, also charges an additional fee known as the ‘arranger’s fee’.

It is also important to note interest payable on any prepayment or delayed repayment - some banks include a penal interest on prepayment because it an untimely repayment reduces their ability to earn interest on that amount.
  1. Repayment Schedule
Most loans are repayable on the expiry of a particular term. Repayment may be of a fixed amount (in lumpsum) at the end of a particular period, or it could be in parts. For example, a loan of INR 10 crores carrying interest of 10 percent per annum (interest payable annually) may be repaid at the end of 3 years (without any repayment of the principal being required for the duration of the loan). This is a case of bullet repayment. Alternately, the loan may have an amortization schedule, portions of the principal may be repayable in parts. This will reduce the overall interest burden as compared a case of bullet repayment (since interest is only paid on the principal, and the amount of principal remaining unpaid is reducing with time), but increases aggregate payments in the short term.

While the interest rate is mentioned on a per annum basis for most loans, the frequency of interest payment is relevant (so that the business can plan its cash flows accordingly) – sometimes interest is payable every six months or on a quarterly basis. Any penal interest rates that are payable in case of a pre-payment or delayed repayment should also be borne in mind.
  1. Security package and guarantees
The security package for a loan can vary depending on the amount of the loan. Unless it is an unsecured loan (which is extremely unlikely for large amounts), banks and financial institutions are likely to insist on a 100 percent or greater security cover, that is, the value of the security should be at least equal to or greater than that of the loan amount.

A lender is usually interested in taking as much security as possible to ensure that he will be able to realize the value of all pending amounts in case of a default. Businesses may be agreeable to it, as long as it does not interfere with the use of the assets in their day-to-day operations.  For high value transactions, the security documentation can be quite complex. Typically, lenders insist on one or more of the following as security:
  • a mortgage of land (and any fixed equipment) owned by the business,
  • hypothecation of all the movable property (in case of a hypothecation, you are allowed to use the property, but if you default in repayment, the bank is allowed to sell the movables and recover outstanding dues from such sale),
  • pledge of shares held by the promoters in the company and
  •  ‘charge’ over any assets that are purchased from the loan
Most institutions will also insist on a personal guarantee from the promoters or of the main holding company in the group (in case the promoter has multiple businesses). They may also require a net-worth certificate from a Chartered Accountant (certifying the individual net-worth of the promoters), in case they are relying on the promoter’s personal guarantee. Guarantees from promoters render the personal assets of the promoters at risk in case there is a default in repayment.
  1. Termination and acceleration
Termination provisions of a loan agreement and the events which can trigger termination rights are extremely important. Every loan agreement stipulates conditions (usually called Events of Default or EODs), occurrence of which gives the right to the lenders to terminate the loan agreement. Failure to make an interest payment can lead to an EOD. In the event of termination, the loan is ‘accelerated’, that is, all pending interest payments and the principal is required payable immediately. Borrowers should carefully understand the circumstances which a lender may call an EOD.

Usually, banks also include ‘cross-default’ clauses in loan agreements – implying that a default under another loan agreement (which is not with the present lender) will give a right to the present lender to terminate and accelerate the present loan. This has the risk that one EOD can accelerate liability under several loans simultaneously and suddenly cause a spike in the payment obligations of the borrower (potentially leading to a ‘winding up’ and liquidation of the borrower’s assets). 
  1. Restrictions on use of proceeds
A lender puts different kinds of restrictions on the business – the essential purpose being that the quality of security or the bank’s rights with respect to the security should not be compromised and that the ownership structure of the business should not change. Typical restrictions imposed to protect these interests are:
  • Prohibition on selling of significant stake in the business, merger or change of control
  • Prohibition from creating any further security over the assets furnished as security for the loan (without the bank’s permission)
  • Change in capital structure, i.e. issuance of further shares
Apart from contractual issues, every loan transaction will involve a number of compliance requirements and regulatory issues, such as obtaining necessary resolutions from the company’s board (and shareholders, where applicable). Stamp duty issues can be quite intricate in loan transactions – the parties to a loan want to minimize the tax paid on the transaction. In case the lender is a foreigner, ECB Regulations will also be attracted.

[1] Monitoring the utilization of loan proceeds may not be very easy or cost-effective for a lender – most banks insist on an annual certificate from the statutory auditor of the company. In practice, some businesses are able to violate the provision on end-use, if the bank does not adequately monitor the utilization of the proceeds). 

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