There is so much talk in the market these days regarding credit availability. Although there may be more credit available than the media would have us all believe, ultimately, those being extended credit seem mostly limited to established businesses with a long and solid credit history. That being said, for those fortunate enough to find credit, an understanding of some of the basics on the underlying credit document – the credit agreement – is essential.
The first step is to understand the objectives of the parties to the credit agreement. Typically, the borrower's basic objective is to: (i) make certain that money will be available when needed; (ii) obtain a loan for as little cost as possible; and (iii) not allow the loan / lender unduly to restrict the borrower's ability to conduct its business. On the flip side, the basic objectives of the revolving lender are to: (i) make money (although, recently, various commercial lenders have been willing to take a longer term view on this objective), (ii) ensure that money need only be disbursed when the borrower's financial footing has not changed; (iii) enable the lender to monitor the borrower's financial situation; (iv) ensure that the lender has adequate protections in the event of a default; and (v) provide an exit strategy.
From that general framework, the credit agreement is derived. Although impossible to discuss every element of the credit agreement, there are five particularly salient items – one being more general and four specific clauses – that tend to cover much of the parties' respective objectives.
Credit agreements are not a one-size fits all proposition. Knowing your business tends to be the most significant challenge in negotiating a credit agreement.
The principal negotiators for the borrower often have a good sense of the current needs and quirks of their own entity. The complexity that often arises relates to ascertaining the future needs of the borrower, the principal negotiators are not always privy to all of the borrower's strategic plans. If the company intends to buy a major competitor in the near future, shift operations to a new market to reduce costs, or make a significant dividend/distribution to its owners during the course of the credit relationship, it is essential that the parties understand how the credit agreement may affect those plans. There are typically only a handful of people in any given organization who have significant involvement in strategic planning. Make certain at least one of those people is willing and able to focus on the credit agreement.
In addition to internal quirks, there are industry quirks that need to be addressed. For instance, a seasonal borrower may not be able to fulfill a static monthly covenant requirement if 80% of the company's total cash flow arrives during the month of December. Particular industries also have unique requirements – and the borrower is going to need to educate the lender on those requirements. For instance, a fishing industry borrower is going to need to comply with the U.S. Maritime Administration restrictions on lending while a high-tech company may need special flexibility on IP licensing issues.
Somehow, definitions can feel like boilerplate – especially in a credit agreement with twenty pages of definitions. This makes it easy for the borrower to want to gloss over the definitions, which would be a major mistake.
Most of the substantive terms (and probably the most negotiated section of the credit agreement) are in the definitions section. The way to best attack the definition section is to go through the agreement and segregate the definitions into at least three different categories: (i) boilerplate – we may need changes to ensure we comply with the representations and warranties, but recognize these may not affect our critical business functions, (ii) financials and (iii) strategic planning.
For financials, consider reviewing and lumping together all definitions that affect pricing, your borrowing base (the amount that you are able to borrower) and financial covenant compliance. For instance, working capital loans often heavily utilize terms such as EBITDA (for pricing and covenant compliance) and Eligible Accounts / Eligible Inventory (to determine what portion of the committed loan you can actually borrow). The initial draft of the terms EBITDA oftentimes will not permit the borrower to address unusual, one-time or non-cash charges that would otherwise affect both your pricing – and perhaps your ability to remain in compliance with the loan. Eligible Accounts, on the other hand, may unfairly exclude accounts that you would expect to be included in your borrowing base (e.g. your particular payment terms with your major client allow 180 days terms, but the credit agreement only allows you to include account with up to 90 day terms).
Strategic planning is often most affected by the affirmative and negative covenants. If a defined term appears in the covenants section, you should query whether or not you need a change to that terms in order to make the covenants work for you.
Although the affirmative covenants are also very important, it seems like (with the benefit of some twenty-twenty hindsight looking back on deals that have closed and for which future waivers have been requested) the restrictions on what you cannot do tend to affect borrower more than the obligations regarding what you must do. Typical negative covenants might include restrictions on liens and indebtedness, restrictions on investments, and restrictions on dividends / distributions.
Liens and indebtedness can be tricky. Although a lender is typically happy to exclude certain ordinary course, short-term liens and certain statutory liens, lenders generally do not want to compete with other lenders and are not willing offer a wholesale exclusion. A couple of ways to address this are: (i) exclude a limited class of assets (e.g. you know that you will need to do some separate equipment financing for a certain type of equipment that is essential to your business, and thus you want to carve this out) or (ii) provide a separate lien/debt basket (i.e. give yourself, subject of course to your needs and the total size of the facility, up to a $1,000,000 worth of assets which can be lien-able without violating the covenant). A warning on baskets, however, is that once a basket number has been proposed, there is a tendency in the lender community to key off the first proposed numbers and apply it to all baskets.
For investments, the lender does not want the borrower to spend money that could be used to repay the loan. The borrower, on the other hand, may need to spend money in order to expand its business, protect against competition or for other purposes. There are a couple of essentials here: (i) you need to be able to repair or replace worn-out facilities and equipment, and (ii) you need to be able to invest in assets, companies, or lines of business that will make you more money or are necessary to ensure you will not lose money. Similar to liens, you will often want to suggest a separate investment basket that you can use with restriction.
Not surprisingly, the lender generally does not want the borrower to make any dividend/distribution payments to owners that could be used to pay down the loan – or at least be retained or re-invested in the company. A couple of ways to address: (i) lenders are almost always willing to let the borrower make dividends / distributions to satisfy the owner's company related tax obligations or (ii) build in a compliance threshold (e.g., so long as your debt service coverage ratio or tangible net worth are at a certain threshold, you are allowed to make distributions).
Perhaps surprising to some, oftentimes the bigger you are, the more likely you are able to limit your covenants. On a syndicated deal (a deal where the size of the loan dictates involving multiple lenders in a lending syndicate), the current trend is to "so called" covenant-lite facilities. Oftentimes, covenant-lite means that there are no financial covenants unless a trigger event occurs.
Unfortunately, covenant-lite loans are not an option for most. The lenders reasoning for financial covenants stem from the obvious desire to monitor the borrower's ability to re-pay the loan to less obvious restrictions set up by the secondary market / ratings agencies and, thereby, the lender's ability to sell the loan.
The borrower should have two goals when negotiating the financial covenants: (i) make certain the covenant requirements are achievable – and, probably, fairly easily achievable and (ii) make certain that the requirements to show compliance with the covenants are not unduly burdensome.
While credit agreements are much more complex than can be illustrated in a brief article, the most simplistic and effective tack in negotiating a credit agreement is to keep your objectives in mind: (i) make certain that money will be available when needed; (ii) obtain a loan for as little cost as possible; and (iii) not allow the loan / lender to unduly restrict your ability to conduct your business.
Mr. Drader is a shareholder with the Seattle, Washington law firm of Graham & Dunn PC and heads the firm's transactional department. He regularly represents lenders and borrowers in various business and real estate loan transactions.