How to Make a Loan to a Company

Almost every company will borrow money at some point to finance its operations. In many cases, the loan will come from a bank. But there may also be times when an individual, such as one of the directors or shareholders of a company, is the lender.

In certain situations it may simply be easier, cheaper, and less restrictive to borrow money from someone other than a bank. In other situations a loan—as opposed to an equity investment—may make sense in order to (i) avoid diluting the interest of the other shareholders in the company through the issue of new shares to the lender, and (ii) give the lender some degree of priority with respect to the repayment of the loan amount if the company becomes insolvent.

Even if you are the sole shareholder in your company, you may want to provide a substantial portion of the financing in the form of a secured loan to the company, because this will give you priority against general creditors as well if the company is wound up due to insolvency (being unable to pay its debts as they fall due).

Regardless of the reasons for a loan and the identity of the lender, formal documents should be put in place to clearly establish the terms of the loan, both for the benefit of the parties involved and relevant third parties. Remember, a loan creates a debt relationship that is not only important with respect to the lender and borrower, it also establishes a relationship vis-a-vis other creditors of the company, including banks and suppliers, as well as to the company’s shareholders.

The principal commercial terms of a loan involve the interest rate, repayment terms, and priority it will be given over other creditors.

Loans can be made on either an interest-free basis or for a specified amount of interest agreed between the borrower and lender. Interest can be determined either at a fixed, variable, or floating rate, and can be either capitalized/compounded or non-capitalized/compounded. As the term suggests, with a fixed-rate loan the rate of interest remains unchanged for the term of the loan. A variable rate loan pegs the interest rate to a specified bank’s base rate, while interest on a floating rate is based on an indicator such as LIBOR (London Inter Bank Offering Rate – the rate of interest charged by banks to one another in London). In each case, an additional percentage is normally added and the rate is adjusted at specified times. For example, the floating interest rate could be adjusted quarterly and set at one percent over the average LIBOR rate for the preceding ten business days.

Non-compounded interest is calculated only on the principal of the loan, while compounded interest is calculated on both the principal and accrued interest (i.e. the interest is “compounded” at specified times by adding it to the principal. When interest is next payable, it is payable on compounded principal – being the principal plus all accrued and compounded interest already added to it).

The principal and interest on loans can be repaid according to a specified schedule over the term of the loan, in a balloon payment at the end of the term, or in a combination of both. For example, on a five-year loan, accumulated interest could be payable monthly and the principal amount payable at the end of the five years. Alternatively, both the interest payments and the principal can be payable in one lump sum at the end of the five-year term. A loan can also be repayable on demand, and will be deemed to be a demand loan if a date for repayment is not supplied.

Lenders can also be offered equity incentives to finance a company. One possibility is to have the principal and/or interest owed on the loan convertible into shares of the company at the discretion of the lender or borrower. If this is the case, then a conversion ratio stating the price per share must be determined – for example, each €10 of the loan will convert into one ordinary share. Another possibility is to grant the lender a warrant (option) to purchase shares in the company. Such a warrant may be exercisable at any time, or only upon the occurrence of certain stated conditions such as where an offer is made to purchase the lending company.

Whether a loan will be secured or unsecured is one of the most important issues that the lender and borrower must address. If the company becomes insolvent, then secured creditors will have first priority over the assets of the company. Preferential creditors (such as the government for unpaid taxes, employee pension schemes and employees who are owed wages) will fall next in line, with unsecured creditors to follow. Shareholders will receive whatever remains after all debts are paid (if anything).

For example, suppose you have loaned €100,000 to a company which is to be wound up (liquidated) because it has become insolvent and unable to pay its debts. Suppose also that it has €1 million in assets but also owes €500,000 to a bank holding a secured debenture/charge over the company’s assets, has no preferential creditors (i.e. owes no money to the Revenue Commissioners or employees), and owes €900,000 to the remaining unsecured creditors. On a distribution of the Company’s assets, the bank will get its €500,000 back and the unsecured creditors—including you—will divvy up the remaining €500,000. Assuming all unsecured creditors are treated equally, you will then receive €50,000 back on your unsecured loan.

Using the same example, if you had loaned the money to the company on a secured basis, then you would have received your entire €100,000 back before the unsecured creditors. In either event, if you had contributed the money in the form of equity and been issued shares, you would have received nothing in the distribution.

For this reason, most lenders will demand a secured loan. There will be situations, however, where this is not possible. For example, a bank which has already lent money to a company may not allow an additional lender to take a security interest in the company’s assets.

In addition to specifying the interest rate, repayment terms, and security interests granted, a Loan Agreement will state the rights and obligations of the lender and the borrower. The principal terms of a Loan Agreement include the following:
  • Loan amount
  • Purpose of the loan
  • Conditions precedent to draw down of the loan
  • Method of draw down of the loan amount
  • Interest
  • Costs
  • Repayment schedule
  • Repayment method
  • Representations and warranties
  • Covenants
  • Events of default

Loans may be made for general purposes, but if the money is to be used for a specific purpose (such as financing the acquisition of a particular piece of equipment) then that purpose should be specified in the Loan Agreement. While it is not required, the borrower may grant the lender the right to monitor how the loan amount is applied, in order to ensure the funds are used for the proper purpose.

If the loan is to be made in one lump sum at the time the Loan Agreement is signed, then all of the conditions that must be satisfied prior to funding the loan will be verified at the time. However, if the loan facility is to be kept open for a period of time, or drawn down in several installments, then certain conditions precedent must be satisfied at the time of the draw down or the lender is not required to fund the installment.

Some common conditions precedent include: all required company approvals have been obtained; the representations and warranties made by the borrower in the Loan Agreement are true and correct at the time of the draw down; no event of default has occurred under the Loan Agreement (e.g. no past interest payment has been missed or the borrower is still solvent); and all documents necessary to perfect a security interest in the company’s assets have been delivered to the lender.

The representations and warranties in a loan agreement serve several functions. First, they focus attention on whether the company has obtained the proper approvals, has the authority to borrow the money, and has disclosed all relevant information to the lender related to the company’s ability to repay the loan. Second, if it is later discovered that the representations and warranties are not materially true and correct, then an event of default will occur and the lender can demand repayment of the loan. Third, the representations and warranties remaining true and correct serve as a condition precedent for future draw-downs of the loan or any loan amounts.

Most Loan Agreements also require the borrower to covenant to take certain actions, and avoid taking other actions (a negative covenant), that would place repayment of the loan in jeopardy. Bank loan agreements often contain financial covenants as well, such as a commitment to maintain minimum debt-equity and other ratios, but these types of covenants are not likely to be included in a Loan Agreement with a non-financial lender.

Covenants typical to any Loan Agreement include an agreement to deliver financial information on a quarterly basis, while negative covenants include an agreement not to change the nature of the business, create any other security interest over the company’s assets, or sell a material amount of assets outside of the ordinary course of business.

A borrower will want as much flexibility to run the business as possible and will not want the loan to become due at inopportune times. As a result, most companies will resist both covenants and representations and warranties that are too strict. Remember that if the borrower materially breaches a covenant or a representation, it will likely result in an event of default under the Loan Agreement and the loan becoming immediately repayable in full.

An event of default will allow the lender to take actions such as accelerating repayment of the loan, turning a term loan into a demand loan, canceling further obligations to lend, and enforcing any security interests that have been granted. Typical events of default include the failure to pay part of the principal loan amount or interest on the date due, insolvency or bankruptcy of the borrower, default under another material agreement (a cross default), and breach of the representations and warranties or covenants. Sometimes a “material adverse change” in the company’s business becomes an event of default, but most borrowers resist this type of provision because of its vagueness. When an event of default is possible to cure, borrowers will try and negotiate a provision allowing them to do so within a reasonable period of time.

If an event of default does occur and the lender wants to force repayment, or if the company does not have sufficient assets to meet all of its obligations and becomes insolvent, a lender will be in a much stronger position if it has made a secured loan.

Comments are closed

Sorry, but you cannot leave a comment for this post.

Connect with Enodare

Enodare Newsletter

Related Legal Forms