In debt financing, when the loan application is approved, the paperwork associated with the loan has just begun. You will now be involved with important documentation. These documents typically include at least:
- The commitment letter
- The loan agreement
- The promissory note
- The security agreement (if required)
Other documents will be required if you are pledging collateral, particularly income-producing collateral. The commitment letter spells out the detailed offer the bank is making. The other important documents are described in the following paragraphs.
The loan agreement is the central document in the lending process. It sets out in detail the terms of the loan. It covers, for example:
- The amount and disbursement of the loan
- Repayment schedule and procedures
- Restrictive covenants
- The company’s representations and warranties
- Special conditions to closing and special fees
- Insurance requirements
- Conditions of default
- How a default can be fixed
WATCH THIS: A very important part of the loan agreement is the section on restrictive covenants. This section lays out the detailed rules the company must live by to be in good standing on the loan. Violation of a covenant usually gives the bank the right to demand immediate full payment.
Restrictive covenants come in two forms: affirmative and negative. Affirmative covenants list specific actions the company must take under the loan agreement. They include the requirement that the company provide the bank with audited financial statements at regular intervals, maintain all property in good condition, and pay all taxes. Negative covenants specify activities that the company can only undertake with the bank’s permission. They require the bank’s permission to put a mortgage on company property, pay stockholders a dividend, increase the owner’s and manager’s salaries, and to merge with another company.
The loan agreement should be reviewed carefully by both you and the company’s legal counsel before being signed. If there are terms that would prove harmful to the company’s progress, revisions should be negotiated. Although lenders want terms that will protect their money, they do not want to harm the borrower.
The promissory note normally contains the key provisions of the loan agreement in summary form. A promissory note specifies the interest rate, the term of the loan, the repayment schedule, whether prepayment is possible without penalty, the conditions under which a lender may declare the borrower in default, and the lender’s rights and remedies in case of a default.
The security agreement is used with a financing statement. A financing statement details the lender’s interest in a specific piece of collateral. Its purpose is to put other creditors or potential creditors on notice that the asset has already been pledged. A financing statement is normally filed with the state and local governments. The particular office of record can depend on the nature of the collateral (personal property, such as equipment, or real estate).