How to make sure this term sheet works for your business
Starting a loan application with a lender always involves meeting with them several times to talk about the business, the purpose of the loan, and sharing the last 2-3 years of financial statements with the lender.
If the lender likes your business and feels there is a potential deal , they will do further diligence and prepare a term sheet.
A term sheet is a nonbinding agreement that outlines the basic terms and conditions of the loan.
A term sheet is nonbinding because it hasn’t been approved by the lender. However, when a lender provides a term sheet, it is a signal of good faith that the financing request can be approved based on the terms outlined within.
So now that you have a term sheet…
In this issue, you will learn:
- The key points to consider within a term sheet
- How to check if the terms work for your company
It’s going to be a fun lesson so let’s jump right in!
The Key Points of a Term Sheet
Here is a sample term sheet we’ll use to pinpoint the key considerations:
|
Borrower: |
ABC Company
(the “Borrower”) |
|
Guarantors: |
XYZ Company (the
“Guarantor”) |
|
Lender: |
The Bank |
|
Credit
Facilities: |
1.
$10,000,000 revolving credit facility (the “Revolver”) 2.
$15,000,000 non-revolving senior term loan
facility (the “Senior Term Loan”) |
|
Purpose: |
1.
Revolver – General working capital and
corporate purposes 2.
Senior Term Loan – To finance the acquisition
of Targetco |
|
Maturity
Date: |
1.
Revolver – On demand 2.
Senior Term Loan – On demand |
|
Availability: |
1.
Revolver – On a revolving basis. 2.
Senior Term Loan – Single draw at closing of
the transaction, with any undrawn amounts cancelled. |
|
Interest
Rate: |
1.
Revolver – Prime + 1.00% / SOFR + 2.50% 2.
Senior Term Loan – Prime + 1.00% / SOFR +
2.50% |
|
Fees: |
Upfront fees:
$100,000 |
|
Amortization: |
1.
Revolver – None 2.
Senior Term Loan – 20 Years |
|
Scheduled
Payments: |
1.
Revolver – Interest only, payable on a monthly
basis and principal paid in full on the applicable Maturity Date 2.
Senior Term Loan – The original principal
amount of the Senior Term Loan shall be repaid in quarterly instalments of
1.25% (5% per annum), along with applicable interest payments, commencing on
the last business day of the first full fiscal quarter of the Borrower after
closing of the Transaction, with any remaining balance due in full on the
Maturity Date. |
|
Prepayments: |
1.
Revolver – N/A 2.
Senior Term Loan – One prepayment is permitted
per year up to 10% of the original loan amount without penalty. |
|
Security: |
·
First ranking general security interest over
all assets of the Borrower and Guarantor ·
Unlimited guarantee from the Guarantor ·
Assignment of all risk insurance ·
Assignment and postponement of shareholder/related
party loans, if any |
|
Financial
Covenants: |
·
Senior Debt to EBITDA ≤ 4.00x for the current
fiscal year, stepping down to 3.50x from Fiscal 2024 and thereafter. ·
Fixed Charge Coverage Ratio ≥
1.10x |
|
Reporting
Covenants: |
·
Quarterly within 45 days: o
Unaudited consolidated financial statements o
Compliance certificates ·
Annually within 120 days: o
Audited consolidated financial statements o
Compliance certificates o
Annual operating budgets |
|
Positive
Covenants: |
Customary but
not excluding: ·
Requirement to maintain adequate insurance
coverage ·
Requirement to keep all taxes current ·
Requirement to maintain the Borrower’s assets
in working condition |
|
Negative
Covenants: |
Customary but
not excluding: ·
No dividends or distributions that will result
in a breach in the Financial Covenants ·
Capital expenditures shall not exceed
$5,000,000 per year |
|
Conditions
Precedent: |
·
Satisfactory review of the Borrower’s
financial statements for the last 3 fiscal years ·
Satisfactory review of the Borrower’s 5 year
projection ·
Satisfactory review of the quality of earnings
report for the Targetco ·
Execution of a share purchase agreement
between the Borrower and the Targetco |
|
Representations
and Warranties: |
Customary
representations and warranties with appropriate temporal, materiality, and
knowledge qualifiers and provision that are customary in a transaction of
this nature. |
|
Governing
Law: |
British
Columbia, Canada |
While every section of the term sheet is important, here are the key points I always address first.
- Credit facilities - The type and size of the credit facility needs to meet the company’s financing requirements. If the facility size is too small, ask the lender explain their underwriting process. The reason could be a lack of security, insufficient sales volumes, high credit risk, or a combination of all 3. By understanding the lender’s limitations, you can push for a higher limit by filling in any missing pieces of information. If you are looking for financing flexibility and the lender offers a term loan, this isn't going to work.
- Amortization - Whenever a term loan is involved, amortization can make or break a deal. The amortization should be set to approximate the remaining useful life of the asset being financed. The longer the amortization, the lower the scheduled principal payments, which eases the pressure to meet financial covenants. When amortization is too short, the company runs into the risk of having insufficient cash flow to both repay the loan while growing the company.
- Guarantees - This is found at the top of the term sheet under “Guarantors” and within the “Security” section. If the business is failing and you have provided a personal guarantee, you are personally obligated to service the loan. This needs to be carefully considered because a default in the business can lead to personal bankruptcy. On the flip side, if you are willing to provide a personal guarantee, this signals to the lender that you are fully committed and believe in the success of the business.
- Negative covenants - These are “promises” that restrict the company from doing a certain action. In the example above, the payout of dividends or distributions is restricted if this action triggers a financial covenant breach. If you don’t take a salary and depend on dividends to satisfy your personal expenses, this will be a problem. Negative covenants can have a broad reach and may lead to many repercussions. Be sure to fully understand what each negative covenant means for you and your business.
- Conditions Precedent - These are conditions that need to be met in order for the loan to close. If there are too many conditions or the conditions are too unrealistic, this can ultimately prevent the deal from closing. Prior to receiving the term sheet, the lender should already have most financial information on hand, which means the conditions should realistically be driven by satisfaction of specific events (i.e. signing share purchase agreement).
Do the terms work for your company?
Once you’ve checked off all the key considerations, it’s time to see if the terms work for your company. The goal is to replicate the financing terms within your financial model to test if there are any red flags.
Incorporate all the details of the loan: the size, interest rates, payment schedules, and financial covenants. Once this is done, check for these deal breakers within the lifetime of the loan:
- Will there ever be a cash flow deficit?
This is the first red flag. If the business can’t generate enough cash flow to service the loans, this deal doesn’t work. Either extend the amortization, lower the interest rate, or reduce the size of the loan.
- Is there sufficient headroom in the financial covenants?
You need to maintain a buffer against financial covenants to manage against business volatility. Operating too close to the financial covenants may end up in a covenant breach. This can put the company into default and allow the lender to demand against the company’s assets. Having additional headroom provides peace of mind.
- Are the financial benefits of taking on the loan worth it?
Some owners are blinded by the fact that a loan can scale up the operations. The more important aspect is to determine whether taking on the loan makes a material impact to the business’s success. For example, if a company borrows $1m to scale up its operations and the result is an increase in net profit by $20,000, is this worth the risk? Borrowing money to grow a company is like walking on a tightrope. You must stay disciplined. Otherwise, a wrong step can spiral you into a world of never ending debt.
Remember, a term sheet is a non-binding agreement. Treat it as a tool for negotiations to outline an offer that works for your company. If there are any terms that don’t line up with your expectations, understand its implications and negotiate a deal that works for you. Once negotiations are done and a term sheet is settled, the lender will underwrite the loan and submit it to their credit committee for approval. Once approved, the next step moves towards a binding Letter of Offer (aka Facility Offer Letter or Credit Agreement).
That's it for this week. Thank you for reading Financing Journey. See you next Saturday.
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