Borrower Tips and Tricks: How to negotiate a financing term sheet
What is a financing term sheet?
A financing term sheet is a document, usually issued by a lender proposing to provide finance to a borrower, which gives an overview of the key commercial terms being offered. Term sheets can vary greatly depending on their purpose, who has issued the document and how definitive the terms are intended to be.
Indicative term sheets or discussion papers are intended to describe preliminary terms and often include heavy disclaimers (e.g. they do not constitute an offer of finance, are subject to further due diligence, and require credit approval). These are usually issued at an early stage and intended to give an outline or flavour of what the lender can provide for a transaction.
A credit approved term sheet is a significantly more serious document, and in most cases indicate that a lender has gone through an internal credit process, conducted its financial due diligence, and obtained credit approval to allow the funding to proceed (subject to documentation and final checks). These term sheets tend to be longer and more detailed. Sometimes, a credit approved term sheet is issued after discussion and negotiation of an indicative term sheet.
Are term sheets legally binding?
Term sheets for financing transactions are by and large non-binding, and will include various statements and disclaimers to give effect to this. However, certain term sheets, particularly those that are described as credit approved, are difficult to depart from in practice once agreed, and therefore a borrower should carefully consider the terms before agreeing to proceed.
Often, the lender may ask the borrower to sign the term sheet. Even where the financing described in the term sheet itself is not binding on the parties, the signing can be intended to bind the borrower to other aspects, such as confidentiality undertakings, payment of legal, due diligence or other costs, and/or payment of an upfront fee for obtaining a credit approval (sometimes referred to as a 'work fee').
Can a borrower negotiate the terms?
Yes, a borrower certainly can and should. Particularly with indicative term sheets and discussion papers, these are intended to invite borrowers to give feedback on the terms offered, before the lender seeks credit approval for the proposal. As the lender is still looking to win the deal, the borrower usually has a stronger bargaining position during the term sheet phase. Therefore, a borrower is more likely to win concessions from the lender during this stage.
All too often we encounter transactions where a borrower has hastily accepted a term sheet, and are forced to 'walk back' or renegotiate terms (at substantial cost or delay) during the documentation process. Agreement upfront to the key terms is essential to a smooth financing outcome.
What should a borrower look for in a term sheet?
The term sheet phase is a great opportunity for the borrower to confirm key commercial terms for a financing and set the tone for the transaction. A borrower should carefully consider all the terms offered, not just the fees and margins, before committing to proceed with the financing.
The following is a non-exhaustive list of what a borrower should typically look out for in a term sheet:
- Amount of funding: whilst the headline number tells a borrower how much the lender is willing to lend, the finer details may prune this back to something less than expected. A facility limit will often be subject to a loan to value ratio, which will fluctuate according to asset values. A valuation that comes back lower than predicted can mean a facility cannot be fully drawn. Further, certain facility limits may be subject to 'headroom' being maintained for various contingencies, so the actual facility amount able to be drawn will be less than the facility limit number.
- Pricing, fees and costs: for a borrower the quantum of these is important, but so is timing and the ability to reduce/recoup any fees should circumstances change. Borrowers should keep an eye out for when establishment fees are payable, when a line fee starts to accrue, exit fees for early reduction or cancellation, and whether ongoing fees are paid in advance or arrears.
- Securities and guarantees required: from a lender perspective, taking more security to protect its position is a key prerogative. However, not all security requested is required or compulsory, and a borrower should consider the cost and restrictions caused by security requested by a lender. For example, a security over a certain bank account often means the borrower cannot make discretionary withdrawals from that account, without first consulting with the lender or meeting certain hurdles. The borrower should consider on a practical level whether the security will inhibit or burden the day to day operation of the borrower's business. Personal guarantees are often required by lenders and may be unavoidable, however, they may also come with additional burdens, such as annual statements of financial position. Borrowers should consider if these burdens are acceptable before agreeing to offer certain securities or guarantees.
- Financial covenants: these should be set with some degree of 'headroom' to allow for fluctuations in a business or a project, without being triggered. Breaches of financial covenants are taken seriously by lenders, so it is imperative that these are agreed at a level where the borrower is comfortable it can meet these parameters. Where a borrower cannot avoid running 'close to the line' on a financial covenant (due to the nature of the business or otherwise), consider if variable covenants are appropriate (such as those that adjust to seasonality) or cure rights can be negotiated in.
- Restrictive covenants: certain restrictive covenants are fairly standard, but there is usually some scope to negotiate carve outs or permissible 'buckets' that give the borrower some flexibility to do business. For example, a negative pledge (a restriction on giving security) is fairly standard, but can be expanded to allow some minor secured financings relating to the borrower (such as equipment funding for photocopiers, motor vehicles, fit out, etc.). The borrower should think about what type of activities it intends to undertake during the term of the financing, and ensure that these activities are not prohibited, or at the very least discuss (and confirm in writing in the term sheet) with the lender the circumstances where such activities will be permitted under the financing. Payment of a dividend, disposal of a substantial asset, or acquisition of another business are examples of activities that are usually restricted under a financing and require the lender's prior written consent.
- Positive obligations: term sheets may include obligations for the borrower to do or obtain certain things. It is incumbent on the borrower to make sure these obligations can be achieved and are not unduly burdensome on the business. Ordinarily innocuous items such as maintaining insurances can become problematic if the level of insurance required is unrealistic, out of market, or expensive to obtain. Timing for reporting and notice obligations should be realistic given the internal resources available to the borrower. Moreover, the borrower should specifically focus on any obligations that involve third parties or items that are outside of the borrower's control, and the consequences if those obligations are be met. Ideally, things that may be outside of the borrower's control, for example, retention of a key staff member or renewal of a key contract, should result in a review event for the facilities rather than an event of default.
- Events of default: at term sheet phase, events of default are usually described in general terms and may refer to 'market standard terms' or 'usual bank standard'. Where specific events of default are included, the borrower should be clear whether any of these may be triggered during the proposed term of the facilities. Again, any items that are outside of the borrower's control should be steered towards being a review event rather than an event of default.
- Conditions precedent: as these are the pre-conditions to the lender providing funding, it is important for the borrower to understand which items cannot be readily satisfied, and take steps to mitigate funding delay. A classic example is obtaining 'rights of entry' deeds with the landlord of leased premises. These third party deeds are often requested by lenders where key premises are leased, but can be subject to significant negotiation with the landlord. If possible, procuring these should be on a 'best endeavours' basis as conditions subsequent, and at the very least, the borrower should engage early with the landlord to procure these in a timely manner. Whilst generic references to 'usual conditions precedent for transactions of this nature' are common, a borrower should be wary of any generic language that gives the lender too much discretion, such as 'any other conditions precedent as required by the lender.'
When should a borrower get help on a financing term sheet?
Ideally, as soon as possible after receiving a term sheet and before acceptance. Having an experienced banking and finance lawyer conduct a legal review during the term sheet phase can be a cost-effective way to ensure a smooth and timely financing process. A borrower's lawyer can assist to identify any 'out of market' terms, negotiate any conditions which do not suit a borrower's business and mitigate any matters which may delay financial close. The cost of a review can be considered minimal in this context.
At the documentation phase, lenders are more reluctant to deviate from what has been offered in its term sheet, and legal costs for negotiation are far greater when the term sheet has already been translated into full facility documentation. Engaging lawyers early on with the term sheet can result in longer-term cost savings for the transaction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.