Business borrowings – stay alert !

The first stage of starting most businesses is focused on a single priority – survival. Some 35%% of start ups don’t make it through the first 2 years. If your business has reached the 2 year milestone, this suggests you have a great product or service and have understood the basics of running a business.

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The first stage of starting most businesses is focused on a single priority – survival.

Some 35%% of start ups don’t make it through the first 2 years. If your business has reached the 2 year milestone, this suggests you have a great product or service and have understood the basics of running a business. You’re entitled to be proud of yourself and take a deep breath.

However, you are now into the next phase of your business and instead of the single threat to your business, generally cashflow, you now face potential problems from different areas. Another 35% of businesses will fail within 5 years (see infographic below).

start up failures

An often overlooked issue in my experience is business borrowing. Having established your business, in many cases, fresh capital is needed to move the business forward. This generally comes from 2 sources, bank borrowing or private equity. The former is far more common but the private equity market has been more active in the last 5 years due to the credit crunch.

Business borrowing often enables the vital capital injection to push a business forward, but inexperienced clients, without the benefit of good advice, often make some basic mistakes. These fall into 2 broad categories :-

  • not negotiating with the lender
  • not understanding the implications of the loan documents

Negotiating with lenders

Almost all bank loan documents are in standard form – typically, there may be the charge documents themselves and also a facility letter.  It is true to say that an approach based on thinking that you can very substantially seek to negotiate the documents or remove clauses will fail and may result in the offer being withdrawn. Banks know what they are doing and most banks have very similar documents. However, there may be elements which can be negotiated or adjusted so as to make them less onerous. The skill is in knowing which elements might be negotiable. This depends on the relative bargaining positions of you and the bank, and also experience, which a commercial lawyer will have.

Many borrowers don’t even think about the possibility of negotiating – understandably they want their business to get the cash injection and as quickly as possible. However, the process of stepping back, considering your options, possible alternatives, implications which aren’t always obvious and the respective negotiating positions of you and the counterparty are all vital skills for the second phase of your business. they are in my view paramount for success.

Understanding the implications of the loan document and the business risks

The issue of  ensuring you understand the technicalities of any loan agreement offers a useful reminder of the importance of this exercise for all contracts for your business. It’s a vital aspect of avoiding problems and spotting opportunities.

Loan agreements will typically involve a number of clauses which have very important implications. The types of clauses can include :-

  • material adverse change clauses
  • financial undertakings generally
  • default and potential Default
  • representations and warranties

It is not only important to understand loan documents and contracts generally but to keep the terms in mind whilst the agreement remains in place. A very common mistake with loan agreements is to simply forget about them after they have been signed and money released. Many businesses end up defaulting due to having forgotten about non-obvious events of default or breaches of undertakings or warranties.  I always strongly recommend that clients refresh and review all contracts every 6 months to a year at most, especially as the types of clauses in bank loan agreements are drafted in such a way as to give the bank stringent powers based on issues which, on a proportional basis, seem completely unfair and disproportionate.

Example – risk becomes reality

there is a highly compelling recent example of what can go wrong. As has been highly publicised, the Royal Bank of Scotland are being investigated for so-called “asset stripping” – see article in Independent here. The following quote from the article spells out exactly my points made above :

“The division handles loans classed as being risky and is understood to have the power to scrap loan deals, impose inflated interest rates and charge hefty penalties.But the report alleges that firms not necessarily in immediate financial distress were “engineered” into GRG, sometimes through small technical breaches of loan terms, such as late filing of minor financial information.”

The Independent uses careful terminology – it describes the above actions as potentially unethical but it does not say they are unlawful, and that’s the point which can easily be overlooked. When you are dealing with a bank as a business customer you don’t have the same legal protections that apply to business to consumer contracts. A minor breach of the agreement, where the contract clause classifies that breach as a major or fundamental breach, can have catastrophic consequences and undo all the hard work you have done to get your business through it’s first few difficult years.

Don’t rely on fairness in insolvency law either – it’s a very grey area in terms of administrations and insolvency and difficult to challenge. That’s a different topic.

David Swede - head of commercial law department
David Swede – head of commercial law department

I would be happy to advise you and your business on how to best deal with the transition from start up survivor to growing business or in relation to loan contracts or other contracts. Please do get in touch.

commercial law • David Swede

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