Companies will often borrow money to cover routine operating expenses, purchase new equipment, acquire another company, and many other transactions involved with business activity. This form of financing is known as a simple debt transaction. As the name suggests, there are also complex debt transactions, which will be discussed in a separate publication. Generally, a debt transaction will involve a lender who will receive a repayment of the borrowed money plus an agreed-upon interest rate and will not receive payment based on the borrower’s performance from the use of the funds. Additionally, if the borrowing company liquidates, lenders are the first to be paid all the money that is owed to them before any payment is made to the company’s shareholders. This is a key distinction between lenders and shareholders of a company, who receive a share in the success of the company. In addition to the differences between lenders and shareholders, there are also differences among the possible classification of the lenders, which include: first priority secured creditors, second priority secured creditors, and unsecured creditors.
There are many options available for structuring debt transactions, including:
A promissory note is an obligation to repay a loan embodied as a contract, which includes certain clauses and provisions. Generally, promissory notes will include the principal, which identifies the amount borrowed; the maturity date, which establishes the date in which the loan must be repaid in full; the interest rate and interest period, which states the cost of the loan and how expenses incurred on the loan will be calculated, and will also clarify if the interest is paid currently or compounded. Additionally, because promissory notes are contacts, common contract provisions concerning governing law, usury or savings clause, and other miscellaneous clauses.
Loan agreements provide the terms and conditions of the whole transaction, rather the terms of the loan itself. Though many simple debt transactions include loan agreements, which help supplement the information of the loan, these terms are not necessary to complete the transaction. There are many types of loan agreements that attach other agreements, clauses, or conditions to the transaction, which often include the following:
Conditions to closing. Closing conditions are elements in a transaction agreement where the parties provide conditions that must be satisfied or waived before the transaction can be completed. Conditions can be imposed on either party.
Covenants or restrictions. Covenants, also often referred to as “restrictions”, are promises where a party agrees to refrain from doing specific things. While covenants can include many actions, usually agreements restrict the borrow from incurring additional debt, paying dividends, or selling the company until the borrowed money has been repaid in full.
Events of default. An event of default allows the lender in a transaction to demand full repayment of the amount borrowed before the scheduled due date. Lenders use events of default as a means of protecting itself from borrowers who will not be able to or do not intend to repay the loan amount.
Representations and warranties. Representations and warranties provide general assurances in a transaction. Specifically, representations are assertions and statements concerning facts and truths regarding a particular item or service, which are used to encourage a party to enter a contract or take an action. Additionally, warranties are promises used to indemnify or find a party blameless when the representation asserted or stated is false.
Warrants. Not to be confused with “warranties” mentioned above, warrants provide the lender of the transaction with the opportunity to purchase the borrower’s stock at a certain price. The warrant clauses will state the number of shares available for purchase and is usually proportionate in value to the amount borrowed.
Occasionally, the borrowers will be required to provide collateral for the loan transaction and will use management shareholders to contribute their shares of the company to satisfy this condition. For these transactions, a pledge agreement is used to create a security interest of the lenders in these shares. Additionally, the pledge agreement will provide the management shareholder’s rights to vote and receive dividends and other economic interest during the duration of the agreement.
Borrowers will often have more than one loan outstanding. For these borrowers, the various lenders supplying the funds to the borrower will enter agreements between themselves, which will establish their respective rights against the borrower. Intercreditor agreements provide which lender shall be paid first, identify a lender’s security interest in the borrower’s collateral, and create a queue for payment in the event the collateral is sold. Additionally, intercreditor agreements provide the procedures to determine which lender can foreclose on the collateral or sue to collect on the loan; when the foreclose can begin; the rights of the parties involved in the foreclosure; and disbursement rate of the funds received when the collateral is sold.
“Subordination” can have multiple applications in the context of simple debt transactions. First, subordination could be used to indicate junior to other debts, with respect to claims on assets. Alternatively, subordination could be used in the context of junior in right of repayments. Generally, subordination agreements are not included in transactions that involve intercreditor agreements, as each of these agreements address the same issue of assigning priority among multiple lenders for repayment and receipt of proceeds following a liquidation but may also include representations and warranties.
The information contained in this post is for general information and educational purposes only. The application and impact of laws can vary widely based on the specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions or inaccuracies in information contained in this publication. Accordingly, the information on this post is provided with the understanding that the author and publishers are not herein engaged in rendering legal, accounting, tax, or other professional advice and services. As such, it should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional.