Lending and Financing

In a lending or financing transaction, a lender loans funds to a borrower. The transaction itself can range in complexity from a simple one page promissory note documenting a loan made by a family member to a complex transaction involving loan agreement, security and guarantees entered into with a financial institution. This article will set out the key steps to a financing transaction and key considerations.

Steps to a Lending Transaction

The first step in most lending transactions is the negotiation of a term sheet or commitment letter which will set out the key terms of the transaction. These terms include the loan amount, interest rate and fees, repayment schedule, conditions to the advance of funds and representations, warranties and covenants of the borrower. The terms sheet will also set out whether security and/or guarantees are required. A loan is secured when a borrower grants the lender an interest in its property to secure its obligations under a loan. A guarantee is when a third party guarantor, such as the borrower's shareholders, guarantees that the borrower will perform its obligations. In the event the borrower fails to perform its obligations, the lender can seek repayment from the guarantor.

The next step is the lender's due diligence. A lender will generally want to review a variety of financial and legal information about the borrower including corporate documentation, financial documentation and documentation about the lender's property. The lender will want to ensure there are no underlying issues or hidden risks, will want to understand the borrower's business, assets and financial position and will want to ensure they will have recourse in the event of an insolvency situation.

If the lender is satisfied with the due diligence review and conditions have been satisfied or waived, the parties will execute the closing documentation which may include loan and, if applicable, security and guarantee agreements, and other required documentation such as inter-creditor or subordination agreements (agreements between creditors about the priority of the pre-existing and current loans and other matters), opinion letters, corporate resolutions and an officer's certificate confirming matters required by the lender.

Key Considerations

A startup's motivation in entering into a financing transaction is its need for funds so the financial terms are an obvious source of attention. However, it is critical that equal attention be paid to the non-financial terms of the loan as the borrower will be entering into a relationship with a set of obligations which will generally last for several years. These include the following:

• Representations and Warranties. Representations are statements of fact that the Borrower is asserting is true. Warranties are a guarantee given by the Borrower. Representations and warranties are important as their breach will typically trigger an event of default (see below). In a typical lending transaction, the borrower will be required to provide representations and warranties regarding matters such as the current and future legal status and authority of the Borrower, the Borrower's compliance with legal and tax requirements, the accuracy of financial disclosure provided to the Lender, ownership of its property, etc.
• Covenants of the Borrower: The loan agreement and related documentation will include positive and negative covenants of the Borrower. Positive covenants are things the Borrower must do, such as continue to operate, maintain insurance, pay taxes and provide financial documents and other reports to the Lender. Negative covenants are things which the Borrower may not do, such as granting an additional security interest over its property without the Lender's consent, fundamental corporate changes such as amalgamating with another corporation or winding up. Borrowers will want to ensure that the covenants do not unduly restrict its operations or impose on it onerous obligations. For example, will the lender's consent be required to engage in certain transactions? Will the borrower be subject to ongoing reporting requirements or required to have its books audited? Failing to give these covenants proper consideration before the transaction is entered into could lead to a non-so-distant case of borrower's remorse.
• Events of Default and Lender Remedies: Borrowers will also want to closely review default provisions and the lender's remedies in the event of default . There are two main categories of default provisions - defaults and events of default. Defaults typically relate to non-material defaults such as failing to provide required documentation by a due date or other breaches which do not result in any financial risk to the lender. Events of default are more serious breaches and can include events such as the borrower ceasing to carry on business, commencing insolvency proceedings or a change of control. At least for standard defaults, included payment-related defaults, borrowers will want to ensure the agreement provides them with a reasonable opportunity to remedy the default without triggering the lender's remedies. A lender's remedies in the event of default can be onerous and generally include the ability to demand immediate payment of the indebtedness and realizing on the security, both of which can be the beginning of the end of the startup.