Avoid costly oversights by double-checking 5 key provisions
Once the term sheet is done and everyone agrees on the deal, the rest can be left to the attorneys, right? Not so fast!
Redbridge has seen multiple examples of terms—even relatively important terms—changing from what was on the term sheet, and we’ve encountered even more examples where what was on the term sheet did not match with the borrower’s understanding of the terms.
A minor mistake in documentation may be fixable, but it can also be a warning sign for misunderstandings, sloppy drafting and even a purposeful change to the terms without prior agreement. Loan agreements are complex, and mistakes can be extremely costly in terms of wasted time, missed business opportunities and damaged relationships.
Common sources of problems
Although transactional attorneys managing relationships usually have years of experience, it should be understood that often a relatively junior attorney may be executing the first draft of the document for the bank, and a junior associate for the borrower’s counsel may be handling the first review. Newer attorneys lack the hard-won experience to spot potential trouble signs and to understand the issues that may turn into hot buttons for the borrower.
Attorneys rarely start from a clean piece of paper when drafting loan documentation; they usually adapt documentation from the bank’s standard form or a previous transaction. Each borrower has different priorities and business drivers, so what works for one client rarely works for another. The bank’s standard agreement is usually more conservative than the terms and restrictions offered to a particular borrower. Many items are glossed over in the term sheet. Each of these items can potentially limit the borrower’s flexibility and lead to inadvertent defaults as many borrowers do not read and fully understand their documentation.
Key provisions to scrutinize
While each agreement is unique, it’s wise to pay attention to these five elements:
- Defined terms: A list of defined terms appears near the beginning of the document. They drive the understanding and interpretation of the rest of the agreement. If a defined term has a different meaning than the plain English that a borrower assumed, it could be a serious fight to win a court battle. Trace all capitalized terms in the credit agreement to all of the defined terms, sometimes three layers or more. Often one defined term contains a reference to a second defined term and so on.
- Financial covenants: These covenants should be tailored to the business plan and expected results. For example, if your company plans to use existing cash on the balance sheet to invest in the business or pay shareholders, make sure that expenditures made from excess cash do not flow through Fixed Charge Coverage Ratios. Even when companies are clear about requirements, the documentation can default to the cookie-cutter situation.
- Nonfinancial covenants: Similar to financial covenants, these provisions should align with plans and expectations. Pay close attention to the process to waive or amend the covenants. Consider allowing the agent bank to have some discretion, within certain limits, to avoid the delay caused by the agent getting approval first and then going to the banks, which will all move at different speeds.
- New trends: When banks struggled with energy loans in the mid-2010s, they began inserting “cash hoarding” language into credit agreements. If more than a certain amount of cash is on the balance sheet for more than a defined number of business days, the borrower must repay the line of credit. This has expanded beyond the energy space, and Redbridge has seen this in some agreements for COVID-impacted industries. Although agreements currently have representations and warranties to state that the company does not believe there is a potential default, cash hoarding language limits the availability of the revolver in a much more structured and severe manner.
- Rate structure: Consider the grid pricing levels, leverage vs. ratings-based pricing, and the timing and frequency of permitted borrowings. Borrowing procedures can force companies to borrow at the alternate base rate due to required minimum notice or a limited number of permitted LIBOR/SOFR borrowings outstanding. The alternate base rate can be 1.5% or more above the LIBOR/SOFR rate! Paying attention to the mechanics of the borrowing process is important.
How to protect yourself
These five elements are by no means an exhaustive list of potential problems and concerns when negotiating loan documentation. Redbridge’s process involves drafting a detailed term sheet, which includes defined terms, detailed baskets, covenants and borrowing mechanics for the financing. This process eliminates last-minute surprises during closing, allows the borrower to dictate terms to the banks and eliminates documentation time by up to 50%.
Schedule time with us today to learn more about market trends and how Redbridge can help!
