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THINGS TO CONSIDER IN A LOAN AGREEMENT

By Neha Agarwal June 01, 2017

THINGS TO CONSIDER IN A LOAN AGREEMENT

In the early stages of a business, taking a loan can be an indication of bleak future and bankruptcy. Mostly, start-ups prefer to raise finance through equity which is more stable than taking a loan. However, it cannot be denied that debt is also an important source of finance. Gradually, Indian banks have started providing loans to Small and Medium Enterprises (SMEs) due to which raising loans has not only become a substitute to financing through equity but a strong source in itself. There are many funding schemes for startups such as the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), the credit guarantee funds mechanism set up under the Start up India Stand Up India Plan, ‘Growth Capital and Equity Assistance’ and SRIJAN Scheme is offered by SIDBI, etc. which have made loan taking much easier.

A loan agreement then becomes an indispensible part. In the making of which there might be various issues which need to be looked upon. This post attempts to highlight key issues in a loan agreement.

It is clear that getting a loan is not a cake walk as lenders would only want to provide a debt if there is an assurance of recovering the loan amount with other payments or the venture seems less risky.

Why are you raising a loan?

You might ask, why will the lender care what you are going to do with the loan amount? Even though the borrower have full assurance to make the payment within the specific period the lender would still be interested in the end-use of the money. The knowledge of the purpose for taking the loan to the lender is important for two basic reasons- it is lenders money, he should know where it is been utilized and another reason is that the terms of the loan agreement change depending upon the end use. (For example, terms of a long term loan- for 5 years will be different from that of a short term loan of 2 years).

Restrictions on the end use of the loan

Banks also put restrictions on the way in which loan amount would be utilized. For example, loan cannot be taken for financing an acquisition of shares. Some other typical restrictions that might be put on use of proceeds can be on

  • Selling of stake in the venture, merger or change of controlling hands
  • Changing the capital structure of the business
  • Creating any further security on the assets that have already been furnished as a collateral

Non-Banking Financial Corporations (NBFCs) may have different restrictions and therefore a careful study should be conducted of loan schemes of various financial institutions and debt should be raised strategically.

Interest rates

There can be two different rates applicable – fixed which remains constant and floatable which is variable and can be pegged to a particular reference rate such as LIBOR – London Interbank Offered Rate in foreign loans or base rate of the Reserve Bank of India.  Some banks may include penal rate of interest rate when payments are delayed. These rates must be understood thoroughly by the borrower and then only an agreement should be entered into.

Terms of Repayment

There can be two ways of repayment- either in lumpsum at the end of the term period (bullet payment) or in parts (amortization schedule). The frequency of the interest payment –which can be payable in every six months or on quarterly basis and not necessarily annual basis-, should also be borne in mind.

Security cover

The security cover on the debt is also a major concern. Some financial institutions insist on a security that is equivalent or greater than the value of the loan raised. There might be some schemes which do not require any collateral at all but that is highly unlikely. The intention of the lender will always be to take as much security as it can, negotiations must be made by the borrowers in cases of unreasonable security cover.

There can be mortgage of land, pledging of shares, charge over assets, hypothecation of moveable properties and even personal guarantee- where the borrower is personally liable in the event of default- as the form of security.

Termination in events of default (EOD)

EOD clause is extremely important as it defines the circumstances under which the lender gets the right to put an end to the loan agreement. EODs can be failure to make timely interest payments, breach of financial covenants, insolvency, material adverse change, etc. Cross default can also be included as an event to call for default by the lenders. In this, if there is default under loan agreement by the borrower with a third party then the lender gets the right to terminate the loan agreement with the borrower. Such conditions need to be studied carefully.

 

 

 

 

 

Sources

http://www.indiafilings.com/learn/bank-loan-startup-business/

https://rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9043

 

 

Tags: loan , agreement , default , interest rates


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