Business Borrowing Basics – Negotiating A Loan Agreement

The Art of the Business Loan Agreement

Cash is king for businesses, especially those just getting off the ground. It’s rare that a company can simply operate from cash flow without short-term borrowing from time to time. A loan agreement is necessary, and the ability to negotiate its terms is equally important.

Even if your business does not have a line of credit or another type of loan with a bank or other professional lender or financial institution, it nonetheless borrows every time it buys on credit, defers payables, or pays its employees in arrears. Often, access to credit determines whether or not a business survives.

Know the Costs and Benefits of Borrowing Money for Business

However, obtaining any credit facility involves costs beyond interest and fees. The terms of any loan and the restrictions placed on borrowers can often determine the benefit (or burden) any loan facility provides to a business.

• How much borrowing is available?
• What will the collateral be?
• How much reporting must the company undertake?
• What restrictions does the loan agreement place on running the business?

All these terms and more are often open to negotiation, regardless of whether your lender suggests otherwise.

As asset-based lending expert Wade Kennedy of Holland & Knight puts it, “In a business loan, there is nothing more important than a flexible, positive relationship between borrower and lender, but circumstances change, as do the bank personnel, and the parties can only truly rely on the terms expressly agreed to in the loan documents.”

Business Loans: Why Negotiate Detailed Terms?

The details always matter, so you should negotiate the best terms you can.

In most loan facilities, you can expect to see some or all of the following legal documents:

• Loan and security agreement(s)
• Guarantees (personal or corporate)
• Stock (equity) pledge agreements
• Reporting documents (compliance and borrowing base certificates)
• Account control agreements (giving lender control over deposit accounts)
• Landlord waivers/access agreements

Standardized vs. Customized Forms in Loan Agreements

Many lenders in the middle market offer loans documented on standardized forms. They use broadly restrictive terms and a fill-in-the-blank structure. This approach provides significant savings on legal expenses. However, these standardized forms contain one-sided terms favorable to the lender.

Such terms might inadvertently saddle your business with covenants and representations you often cannot keep—and to which you should not agree. If your business wants or needs greater flexibility (and the prospect of more favorable terms), a negotiated set of nominally “customized” loan documents is typically the approach you should take with your lender.

Most lenders are willing to negotiate a package of loan documentation so long as the process begins with a set of base forms with which the lender is familiar.

How Much Negotiating Power Does a Business Have?

A borrower can obtain significant benefits and concessions from most lenders beyond the basic economic terms of the loan (interest rate, term, security, and fees). The ability to negotiate these terms depends on the following:

• Creditworthiness of the business
• The presence of competing lenders
• Market conditions

Borrowers should keep in mind that lending institutions are like any other business: they need customers. If more than one lender is willing to loan to your business, then you have some leverage.

When Should I Start Negotiating My Business Loan?

You should start negotiating immediately. A proposal letter (or commitment letter) and term sheet are typically the first documents a lender asks a borrower to sign, but the negotiation of the loan agreement has likely already begun with phone calls and emails.

Also, the term sheet will be the first document that goes beyond the basics of pricing, tenor, and fees. It delves into terms relating to scheduled payments and prepayments, collateral, closing deliveries, financial covenants, and the event of default—that is when the negotiation should begin in earnest.

A lender will hold you to the terms set out in an agreed-upon term sheet, and that is when a borrower should engage counsel. Begin thinking through the transaction, its documentation, and its structure.

“There is nothing wrong with accepting general terms that are ‘market’ for similarly situated borrowers,” Kennedy says. “A smart lender will not present terms it knows a borrower has no reason or ability to comply with. It can be a financial (and sometimes strategic) mistake to try to negotiate every provision in a loan document.”

Negotiate the Most Important Provisions

Legal counsel can help guide the borrower through the loan documentation and point out the provisions that are typically most important to the company.

In many instances, the term sheet outlines these very effectively, but the detailed terms must work with the borrower’s business and operating requirements. You should be able to get answers to a number of questions, including:

• Can I borrow money and get the proceeds when and how I need them?
• Can I provide the financial reporting with the frequency and detail required?
• Do the covenants allow me to enter into transactions I know I need?

If the answer to these and similar questions is “no,” then that is likely an area for negotiation. Everything else probably falls into the “nice to have” category but is not worth going to the mat over.

It always makes sense for a business owner to read the loan agreement they are signing. This may sound obvious, but skipping over “boilerplate” or relying too much on legal counsel to review business terms often results in documentation contrary to how an individual business runs. You want to avoid this. 

So, a strategy that focuses on the most important provisions tends to be the most cost and time-effective. Business owners can save a lot of money on attorney fees by limiting the negotiation to a few key items, and this strategy also cuts down on time to close.

Choosing an Attorney for Your Loan Agreement

Engaging an experienced attorney who is knowledgeable about the type of loan you seek and willing to learn about your business can help create an efficient approach to negotiating and closing a loan agreement.

General inexperience, not knowing the market for your specific type of loan, or simply wanting to appear to be doing an effective job can all result in “over-lawyering.” To avoid this, ask questions of your attorney both upfront and throughout the process, such as:

• Have you negotiated many of these types of deals recently?
• Why do I need this provision?

Good counsel will always happily explain their expertise and the importance behind the specific terms to which you agree.

If you aren’t familiar with common market terms, no matter how likely they are to be negotiated, your attorney should be able to explain them to you. 

Common Provisions to Negotiate

As noted above, the term sheet sets out many of the most important terms of a loan transaction, including the maximum amount to be borrowed, interest rates, repayment terms, fees and costs payable, collateral, key financial covenants, and certain defaults.  

The actual documentation provides more detail, but the usual points of critical interest to a borrower include the following:

• Borrowing mechanics 
• Calculation of the borrowing base (for asset-based loans)
• Eligibility requirements and exclusions
• Cash dominion (controlled accounts and cash sweep provisions)
• Calculation of EBITDA for financial covenants and related definitions
• Affirmative covenants. The borrower agrees to:
  • Notice of adverse event
  • Delivery of financial information
  • Allowing lender to enter and inspect premises and records
  • Compliance with laws and maintaining insurance
• Negative covenants. The borrower agrees not to:
  • Incur other debt
  • Sell assets
  • Incur liens
  • Make investments
  • Make dividends
  • Dissolve or wind up the business

How Far Should You Go With Negotiations?

When determining the course of your loan agreement, the main considerations are cost and necessity. Think of it like buying a car. 

You can get the more economical base model with stock features, but you may not get the special features you need, such as anti-lock brakes and four-wheel drive. If these options are important to you, spending extra money on them means getting a vehicle that better suits your needs. 

Some car buyers may choose a custom car, hand-selecting every detail of the build and adding extras like spinning rims and underbody lights. Most people won’t need this level of customization.

So, in terms of your loan facility, a fill-in-the-blank document (comparable to the base-model car) is perfectly acceptable for many businesses. You still need a lawyer to review and explain the document, but this option allows minimal time and expense, all depending on the attorney’s hourly rate. 

Customizing Your Loan Agreement: Pros and Cons

However, this type of “base-model” loan may contain onerous and narrow restrictions on how the company can run its business. Beware; it may also provide maximum flexibility for the lender to withhold credit or declare a default and withdraw the line entirely if any conditions change.

The other extreme is a truly customized loan agreement, comparable to the tricked-out custom car. In this case, you negotiate every provision, regardless of whether it is a critical need, and ask permission from the lender to deviate from the restrictions in the agreement. 

Detailed negotiation can provide greater exceptions to general prohibitions in case you need them in the future. This, however, takes time and creates expenses for you and the lender. Remember, you will be paying the lender’s legal fees as well as your own. 

So, for most businesses, a better approach is to stick to the base model.

Important Considerations for Knowing How Far to Negotiate

Ask for the things you really anticipate needing, such as more time to deliver monthly statements or more availability at the time of year when production ramps up. But leave the rest to a market approach. If you don’t foresee needing a lot of additional capital for acquisitions, don’t ask for a pre-agreed incremental facility increase and a detailed definition of permitted acquisitions.

Just remember: You only get what you pay for. Expect some time and expense while your attorney fights with the lender’s counsel over what special terms you need and how they work. Getting these details right at the outset avoids additional time, expense, and lender fees down the road.

The Benefits of Negotiating

• The ability to trade for or modify terms
• Major upside with relatively little downside 
• Assurance that the agreement is thought-out and vetted thoroughly

Potential Pitfalls of Over-Negotiating

• Both sides may incur additional costs, including time spent
• Potential to begin a banking relationship on a sour note
• Some negotiated items may never come into play.
• Detailed negotiation may eliminate wiggle room or space for interpretation

Pros and Cons of Ambiguity in a Loan Agreement

Obviously, some terms in a loan agreement require certainty and precision, such as how much you can borrow, when the loan is due, and what costs and fees are involved. 

These are all questions that should be readily answerable. Other terms are more ambiguous — whether by necessity or choice. A few such examples in loan documentation include:

• Timing of deliveries and notice: “promptly” vs. “within three business days”
• Compliance: “in all material respects” and “material adverse effect”
• Borrower discretion: “reasonable business judgment” and “ordinary course of business”
• Lender discretion: “sole discretion” and “permitted discretion”
• Events of default: “Material adverse change”

Look for those areas in which you may be hamstrung by imprecise terms. 

If negative covenants only permit an action being taken “in the ordinary course of business,” the borrower should be comfortable making that call. If the lender enjoys wide discretion in excluding collateral from the borrowing base or determining if a default has occurred, the borrower should ensure it has a good working relationship with the lender.

At the end of the day, negotiating an excruciating level of detail into the loan agreement will be expensive and the borrower should decide if that is worth the cost.

Business Borrowing Requires Mutual Trust

To a certain degree, accepting a loan from a lender is an act of trust – for both parties. The lender entrusts the borrower to comply with the loan agreement. The lender faces limited options once you finalize the loan, and enforcement is expensive and time-consuming. The borrower entrusts the lender to be reasonable and flexible in managing the loan. There are always many discretionary “hooks” upon which to hang a default or limit credit, should the lender so choose. 

Kennedy concludes: “Getting the critical terms agreed to early avoids costly adjustments in documentation and structure down the road and sets core expectations at the outset. It also doesn’t hurt to let your lender know you mean business and expect thoughtful terms. They can’t just throw in the kitchen sink and expect that you will agree. It says, ‘I want a market deal here, and I’m willing to work for it.’”

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Negotiating an M&A Deal
2. Valuation / What’s it Worth? Valuing a Business for Sale
3. What Kind Of Loan?

This is an updated version of an article originally published on March 7, 2017, and recently republished on March 30, 2020.]

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