Negotiating a Line of Credit Facility with a Commercial Bank

by: Ed Hirsch, MMM Corporate Technology Group and Neal Miller, TechCFO
This FAQ (frequently asked questions) provides answers to important questions for entrepreneurs to consider in negotiating a line of credit and other lending arrangements with commercial banks.  This FAQ can also serve as a sample checklist of relevant issues for your company in connection with bank financing.  Please note that other questions may be relevant to your company, and this is not a comprehensive review of all important issues.

 

1. Is this the right time for my company to pursue debt financing at a credit facility?  There are several key considerations for an entrepreneurial company to review to determine the advisability of debt financing.  They include:

A. Stage of Company – Startup or very early stage companies will have a difficult time obtaining debt financing. This is due to lack of revenue, customers or other financial resources. Financial institutions typically do not provide startup financing.

B. Financial performance – To the extent a company has revenue, and more importantly, profits, the likelihood of obtaining debt financing greatly increases. Most financial institutions look to cash flow from operations for repayment of debt.

2. What are the different forms of debt financing available to a technology company and what are their key attributes?

The following is a summary of the principal forms of debt financing generally considered by growing technology companies:

A. Revolving Line of Credit – Lines of credit typically have a maximum amount that can be borrowed, and the “borrowing base amount” is usually a percentage of Accounts Receivable, Inventory or some other asset base. The Company usually reports monthly on the borrowing base, and can either draw, or must repay amounts under the line based on the amounts available to borrow.

B. Term Loan – A term loan typically has a fixed interest and repayment period. Term loans are typically provided to finance capital expenditures or other hard asset acquisitions.

C. Factoring Arrangements – Factoring arrangements typically provide for financing of specific customer invoices from Accounts Receivable. The lender advances a percentage of the invoice value, and the loan amount, plus interest and fees is repaid when the customer invoice is paid.

D. Receivables Exchanges – This is a relatively new internet based concept, where lenders will bid to lend against specific customer accounts, typically based on the credit of the end customer. They will advance a net amount of the invoice value (face amount, less interest and fees) and collect the invoice from the end customer.

E. Capital Lease Financing – Similar to term loans, capital leases are typically only for capital expenditures, and come in several forms – either purchase financing, where the full amount of the equipment value is financed, or fair market value leases, where the lease payments are smaller, and the company either returns the equipment to the lender at the end of the term, or purchases it for the fair market value at the end of the lease.

3. What makes debt financing more attractive than raising equity?

The main attractiveness of debt financing is the absence of equity dilution to existing shareholders.  Many entrepreneurs want to retain as much equity as possible and sell stock only when the company can achieve a high valuation and minimize dilution.  Debt financing can provide needed capital for growth without substantial negative impact on the existing shareholders.  However, note that some commercial lenders may require a warrant to buy equity as part of a financing arrangement (see discussion below regarding warrant coverage).

4. What type of debt financing is best for a technology company?

The forms of debt financing described below are structured to address and fund different company goals, as follows:

A. Revolving Line of Credit, Factoring Arrangements and Receivables Exchanges – are  designed to address financing needs such as weekly/monthly working capital peaks and valleys as the company grows and has increasing receivables balances.

B. Term Loan – Term loans are generally made for the purpose of financing Capital expenditures and acquisitions – generally for fixed amounts, and where the company has projected future cash flows to repay the loan.
The best type of financing for each company will be dependent on its stage, and the purpose for which the financing is needed. Additionally, lenders will look to the collateral that is available to secure the loan. For example, for equipment financing, a term loan that is secured only by the equipment that is being financed is the best approach for the company. For other lines of credit, lenders will typically look for some form of “blanket” lien on all company assets. See a further discussion on collateral pledges below.

5. Do most debt financings for tech companies involve a pledge of collateral and grant of a security interest?  If so, how is a security interest granted and what does it mean to “perfect” a security interest?

Yes, most debt financings require a pledge of the tech company’s assets to secure the indebtedness, meaning that on an event of default that is not cured by the company/debtor, the assets can be seized and may be sold with the cash proceeds applied to pay off the debt.

A security interest is created through a writing where the company/debtor grants a security interest in certain assets described as collateral that are pledged against the debt.  A security interest is created under Article 9 of the Uniform Commercial Code (adopted in most of the states).  A security interest is “perfected” by the lender to allow the lender to maintain its priority against other parties who may have a security interest or other legal interests in the collateral.  The manner of “perfection” is specified in Article 9 and often requires the filing a UCC-1 Financing Statement, a simple form that must be filed in the appropriate government agency.
As mentioned above, the extent and type of collateral required will be different for each type of debt instrument provided. It is important for the company not to grant too broad a pledge of collateral for the type of financing being obtained.

6.  What are the due diligence considerations for a commercial bank in determining whether to extend debt financing to a technology company?

A commercial bank generally uses a checklist to determine whether a company is an adequate credit risk for purposes of extending debt financing.  Key considerations for the commercial bank may include:

a) Historical financial information, including credit history;

b) Financial projections including financial ratios such as debt to equity and cash flow coverage ratios;

c) Equity investors and/or amount of equity in the company from company founders; and

d) Product / customer references.

The lender’s key goal is to determine how the loan will be repaid, which determines how much risk they are taking, and impacts the pricing considerations on the loan. Particularly in the current environment, lenders have strict underwriting rules that they must follow in providing debt financing. This has made it more difficult to obtain debt financing than in years past.

7. What are the most common financial covenants included in debt financings that a tech company must satisfy in order to avoid an event of default?

Financial covenants will depend on the credit history, stage of the company, perceived financial risk and financial backing, if any.
The typical key financial covenants are:

a) EBITDA/Net Income Covenant – this could be a minimum net income, or maximum loss allowed;

b) Liquidity Ratio – Cash plus Accounts Receivable divided by the bank debt;

c) Debt / Equity Ratio – The total amount of debt the company is allowed to have, as a percentage of total equity;

d) Minimum Net Worth – This is the total amount of shareholders’ equity reported in the company financial statements; and

e) Financial reporting – Typically, this involves monthly reporting of financial results, reports on borrowing base calculations and providing an annual budget.

In addition to financial covenants, many credit facilities contain “negative” covenants, meaning the company may not do certain things without obtaining the bank’s advance approval. These types of covenants often include:

a) Acquisition of another company or significant assets;

b) Incurring additional debt above a pre-agreed amount;

c) Disposing of assets or portions of the business; and

d) Distributions of dividends or other amounts to shareholders.
 

8. What are the most common “events of default” in debt financing arrangements and how can they be cured to avoid legal liability?

The most common events of default described in most debt financing documents typically include breaching one of the financial covenants mentioned above, or performing one of the “negative” covenants.

The most typical situation that tech companies experience is missing their financial plan. Product development takes longer or costs more, or customer sales ramp is slower than expected. This results in negative cash flows in excess of what was projected, and typically results in a default of one or more of the financial covenants listed above.

When selecting a banking institution to work with, it is important to check with references regarding how they act if/when an event of default occurs. Curing an event of default depends mainly on how it occurred. Typically, the easiest cure is the infusion of additional equity capital into the company. Where this is not feasible, the company will need to work with the bank on a plan to cure the default and avoid a situation where the bank seizes company assets.

9. How often will a commercial lender request a warrant as part of the debt financing and what are the usual terms for such warrant coverage?

Additionally, how often are these warrants granted as “cheap” warrants meaning that they are exercisable for a nominal payment.

As a general rule, warrant coverage is requested by lenders where the tech company is young and may be entering into its first debt financing.  Also, if a technology company has experienced financial difficulties, the commercial lender may request warrant coverage as a further way of providing upside opportunity for risky credit situations.  The key provisions of warrants are: 7-10 year warrant life, immediately exercisable, nominal strike price for common stock and prior round price for preferred stock.

10. What are key legal documents involved in most debt financing arrangements and who prepares them?

The key legal documents are:

A. Loan Agreement
B. Promissory Note
C. Security Agreement
D. Subordination Agreement
E. UCC-1 Financing Statement
F. Consents and Waivers
G. Board of Directors Actions
H. Stockholder Approval
I. Compliance Certificates

11. How often will a commercial lender require a personal guarantee of the indebtedness and what are the key terms of a guarantee agreement?  Are the founders often required to sign personal guarantees?

A number of early stage technology companies that are not venture capital backed will be required to provide personal guarantees from the founders.  As the company matures and grows, a refinancing can occur and the personal guarantees may be removed.  The key provisions of a personal guarantee provide that if any obligations owed under the loan arrangement are not satisfied in full by the borrower, the guarantor will be obligated to satisfy such obligations regardless of the borrower’s situation.

12. What events will cause a financing to have to be paid off in full?  If a company is sold or there is a change of control, will the loan have to be paid off?

The financing documents will include several provisions that may require acceleration and payment of the outstanding principal and interest.  This may also include an “event of default” that is not cured.  In many cases, a sale of a company or change of control can trigger these acceleration provisions.  It is important to define a “change of control” carefully so that a subsequent equity financing does not prematurely trigger acceleration of the indebtedness and a requirement for it to be paid off.

13. What is meant by a “refinancing” and when should it be considered by a technology company that has incurred debt?

The term “refinancing” has various meanings and generally includes a restructuring or entering into new terms that are materially different from the original financing provided by the lender.  A refinancing may also include the substitution of a new lender for the existing one (where the existing lender is paid off and a new bank becomes the source of debt financing).  Refinancings are very common where a technology company is growing rapidly and can negotiate more favorable financing terms.

Typically, a refinancing within a certain amount of time after the original loan is issued will require payment of an early termination fee to the lender. This should be taken into consideration in any refinancing arrangement.

14. What impact does debt financing have on the ability of a company to raise venture capital?

Generally, a well structured debt financing will not impair the ability of a tech company to obtain equity financing.  The venture capitalists providing the equity may require that the funds from the equity financing not be used to pay off any outstanding indebtedness without approval from the venture fund or preferred investors.

15. What are the most important points for a technology company to keep in mind in connection with the debt financing?

There are several key points that the tech companies should always keep in mind in connection with debt financing, including:

A. Event of Defaults – the documents should be carefully reviewed to determine all of the events of default, especially with regard to covenant non-compliance.  The tech company may want to report on an ongoing basis to its Board of Directors regarding covenant compliance and any issues that may be foreseen in this area.

B. Negative Covenants – make sure you understand the scope of these restrictions on the ability to run your company.  Bank approval may be necessary in order to take actions that otherwise would be in violation of these restrictions or negative covenants.

C.  Financial Covenants – make sure that you are comfortable with your ability to meet the financial covenants agreed to, especially in the near term after entering the loan agreement. Covenant defaults early on can strain the relationship with the lender, make company operations difficult and typically require fees to be paid to the lender and additional warrants to be issued to the lender.

This information is presented for educational purposes and is not intended to constitute legal advice. Opinions expressed are those of the author and not of Morris, Manning & Martin, LLP; see disclaimer at http://www.www.mmmtechlaw.com/privacy-policy-and-disclaimer/. Contact Ed Hirsch for more information at edh@mmmlaw.com